ISSUE NO. 187
PUBLISHED SINCE 1991
April to June 2013
Jamatul Thani - Sha’ban 1434
NEWHORIZON

GLOBAL PERSPECTIVE ON ISLAMIC BANKING & INSURANCE

Al-Azhar Moque, Cairo, Egypt

POINT OF VIEW: SEQUELAE OF THE DOW JONES FATWA AND EVOLUTION IN ISLAMIC FINANCE

ANALYSIS: THE SUBPRIME CRISIS AND THE LESSONS FOR THE ISLAMIC FINANCE INDUSTRY

TAKAFUL: THE INTERNATIONAL TAKAFUL SUMMIT 2013

ACADEMIC ARTICLE: THE OJECTIVES OF THE SHARI’AH IN ISLAMIC FINANCE: IDENTIFYING THE ENDS AND THE MEANS

COUNTRY FOCUS: THE GROWTH OF ISLAMIC FINANCE IN EGYPT – A HOSTAGE TO POLITICAL AND ECONOMIC STABILITY

FOOD FOR THOUGHT: FORM AND SUBSTANCE


NEWHORIZON    April to June 2013 CONTENTS

Features


Sequelae of the Dow Jones Fatwa and Evolution in Islamic Finance: The Real Estate Investment Example

Michael McMillen examines evolutionary developments in Islamic finance since 1998.


The Subprime Crisis and the Lessons for the Islamic Finance Industry

Meezan Bank’s Suleman Muhammad Ali looks at the lessons of the subprime crisis in relation to the Islamic finance industry. He argues that the industry cannot afford to be complacent and also suggests that appropriate and efficient regulation is needed to control market behaviour.

The International Takaful Summit 2013 in Cairo, Egypt

An overview of the proceedings and report of the takaful awards

Jeddah Roundtable Declaration Fosters a Greater Consensus on the Future Direction of Islamic Finance

A report of the proceedings of the 3rd roundtable event organised jointly by the International Shari’ah Research Academy for Islamic finance (ISRA), in collaboration with the Islamic Research and Training Institute (IRTI) and Durham University.

The Growth of Islamic Finance in Egypt - a Hostage to Political and Economic Stability

Tentative steps towards a stronger Islamic finance industry in Egypt are once again on hold as the country’s fragile, infant democracy goes onto life support.


Form and Substance

Shaikh Muddassir Siddiqui discusses the problems created by Islamic financial contracts, particularly in cases of bankruptcy. He argues that efficient and workable bankruptcy codes are essential for the economic wellbeing of society.


Islamic Finance and Shari’ah Compliance: Reality and Expectations

This report of a lecture given by Dr Frank Vogel at the London School of Economics suggests that Shari’ah scholars today are being unfairly burdened with the application of Shari’ah to business and finance. He points out that historically merchants, rulers, guilds and others all played a part.

NEWHORIZON    Jamatul Thani - Sha’ban 1434EDITORIAL

Executive Editor’s Note

In the hurly burly of our modern existence it is all too easy to lose sight of the basic rationale for what we are trying to do. We also tend to forget that, broadly speaking, the issues we face are not new or unique and that the past may have something to teach us.

As you read the article in this issue, ‘The Objectives of the Shari’ah in Islamic Finance: Identifying the Ends and the Means’, you may feel that the aim of creating a fair and just society is a noble thought, but it is just that, a noble thought, with no real relevance to 21st century finance and commerce. The authors, however, argue convincingly that it is this basic rationale, the Maqasid al-Shari’ah, that should make Islamic finance markedly different from its conventional counterpart in its present form. They argue that the legalistic approach that has characterised much of Islamic finance since the 1970s falls woefully short of meeting the broader aims of creating benefit and preventing harm.

Is it only the responsibility of the Shari’ah scholars to ensure that these aims are being met? In part, yes, but as Dr Vogel pointed out in a lecture at the London School of Economics, it is not solely their responsibility. He highlights the fact that historically the merchant community itself, regulators and rulers or governments played a key role, incorporating scholarly rulings into the context of the broader needs of society and enforcing regulations. Given the multi-national nature of finance in the modern world, he suggests that the task of determining the future direction of Islamic finance should perhaps be in the hands of industry bodies such AAOIFI, although that assumes all the nations and institutions can be persuaded to accept and implement the rulings of such bodies.

If Islamic finance is to achieve its true potential as an equitable and ethical financial system, it needs to have the courage not only to appear to be different, but to be truly different by placing faith in the Maqasid al-Shari’ah. It also needs to broaden its appeal to attract the wider population banking with conventional banks, as well as non-Muslim customers looking for an alternative to the tarnished conventional system. Those who serve in the Islamic finance industry need to scrutinise their role and understand what actions and intentions are moral and immoral. Actions can be made to appear perfectly legal but are nonetheless unjust and reprehensible as defined in Shari’ah.

Qayyum Signature

Mohammad Ali Qayyum
Director General
IIBI

Deal not unjustly, and ye shall not be dealt with unjustly.

Surat Al Baqara, Holy Quran

EXECUTIVE EDITOR
Mohammad Ali Qayyum,
Director General, IIBI

EDITOR
Andrea Wharton

IIBI EDITOR
Rahim Ali

IIBI EDITORIAL ADVISORY PANEL
Mohammad Shafique
Iqbal Khan
M Iqbal Asaria
Mohammed Amin
Stella Cox
Richard T de Belder
Ajmal Bhatty
Mufti Abdul Qadir Barkatullah
Dr Imran Ashraf Usmani

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This magazine is published to provide information on developments in Islamic finance, and not to provide professional advice. The views expressed in the articles are those of the authors alone and should not be attributed to the organisations they are associated with or their management. Any errors and omissions are the sole responsibility of the authors. The Publishers, Editors and Contributors accept no responsibility to any person who acts, or refrains from acting, based upon any material published in the magazine. The Editorial Advisory Panel exists to provide general advice to the editors regarding matters that may be of interest to readers. All decisions regarding the published content of the magazine are the sole responsibility of the Editors, and the Editorial Advisory Panel accepts no responsibility for the content.
NEWHORIZON    April to June 2013 News

Turkey and the Qatar Financial Centre Tax Laws Most Favourable for Islamic Finance

Turkey and the Qatar Financial Centre (QFC) have the most Islamic-finance-friendly tax systems out of eight countries in the MENA region according to a study by the Qatar Financial Centre Authority in partnership with the International Tax and Investment Centre, based in Washington DC. The study, ‘Cross border taxation of Islamic finance in the MENA region - Phase One’, shows that while simpler Islamic finance transactions can be carried out in some countries without prohibitive tax costs, of the countries reviewed only Turkey and the QFC have a tax system that enables sukuk transactions to be carried out without excessive tax costs.

Mohammed Amin

The study goes on to examine the two alternative approaches a country can take to update its tax system to support Islamic finance transactions (referred to in the study as the UK model and the Malaysian model). It concludes that the Malaysian model is the one that is quicker and simpler to implement for Muslim majority countries.

Mohammed Amin, the report’s main author commented, ‘The Malaysian approach, which the report recommends, is based upon the regulatory authorities putting in place a process for advance determination of whether a transaction does or does not constitute Islamic finance. For those transactions which are certified as being Islamic finance, tax law can be modified relatively easily to give them the same taxation outcome as the equivalent conventional transactions. Where intermediate transactions are necessary to effect the Islamic finance structure, the intermediate transactions can be readily disregarded for tax purposes. The United Kingdom approach, which we also reviewed, requires much more complex drafting of tax law, since no reference can be made to external Islamic finance sources, although the UK’s secular approach does have the merit of keeping religion out of tax law.’

The study reviewed the tax treatment of four common Islamic finance structures, commodity murabaha, sukuk, salaam and istisna in eight MENA region countries Egypt, Jordan, Kuwait, Libya, Oman, Qatar, Saudi Arabia and Turkey and also in the Qatar Financial Centre. The detailed research work was led by Mohammed Amin who is an experienced Islamic finance consultant and was previously UK Head of Islamic Finance at PricewaterhouseCoopers LLP, with the collaboration of Salah Gueydi, Senior Tax Advisor, Ministry of Economy & Finance, Qatar and Hafiz Choudhury, Tax Administration and Policy Advisor, International Tax and Investment Centre. Ernst & Young’s Qatar office coordinated the distribution

of questionnaires to Ernst & Young’s offices in the MENA region for completion and review by country tax authorities while PricewaterhouseCoopers Malaysia completed a questionnaire for Malaysia to provide a comparison from outside the MENA region. The United Kingdom provided a second non-MENA comparison, based upon Mohammed Amin’s knowledge as a UK tax advisor. The report is the first of a series. The team intends to extend the work in future studies to cover, for example, the impact of consumption taxes such as Value Added Tax on Islamic finance transactions, the cross border treatment of Islamic finance transactions within international double tax treaty arrangements designed primarily with conventional finance in mind, the zakat treatment of Islamic finance transactions and the Shari’ah governance framework for Islamic finance. Other countries in the MENA region may also be reviewed in subsequent reports.

Ian Anderson, Chief Finance and Tax Officer at the QFC Authority welcomed the report, saying, ‘Islamic finance is of growing importance within the MENA region, but the taxation systems of almost all MENA countries were developed in an environment of conventional finance. This too often means that Islamic finance suffers an additional and therefore unfair tax burden not borne by conventional finance. This report points out the best way forward to help level the playing field in the MENA region and potentially beyond.’

QFC Survey is Downbeat on Takaful

The Qatar Financial Centre (QFC) Authority has published its first annual MENA Insurance Barometer, which builds on the GCC Insurance Barometer, first released in 2012. The interviewees expressed strong confidence in the future of the region’s insurance sector with 68% of respondents expecting MENA insurance premiums to grow faster than the region’s Gross Domestic Product (GDP), despite challenges arising from the Arab Spring and geo-political tensions. They were, however, less positive about the takaful market.

The prospects of takaful insurance are viewed critically. Only 38% of respondents expect this market segment to outgrow total insurance premiums (18% said it would grow more slowly than the total market) and many respondents to the survey felt that the prospects for takaful had been overestimated. Business models for takaful insurance are believed to be in need of a thorough review.

NEWHORIZON    Jamatul Thani - Sha’ban 1434 News

UK Government Reaffirms its Commitment to Supporting Islamic Finance

A reception held in London’s Palace of Westminster was perhaps more interesting for what the participants did not say rather than what they did. Farmida Bi, European head of Islamic Finance at Norton Rose speaking at the reception said, ‘We are seeing a growing appetite for Islamically-compliant UK assets. Interest in UK real estate remains strong and the UK Islamic finance industry continues to innovate in response to investor demand for UK assets. Further Government support for the industry would be welcomed.’

Could she possibly have been referring to the much vaunted idea of a UK sovereign sukuk? If she was, she may have been disappointed by the comments of the Rt Hon Vince Cable, Secretary of State for Business, Innovation and Skills, who said, ‘Islamic finance can help to promote growth in the UK economy and provide much needed revenue and investment at a time when conventional liquidity is in short supply. In the current economic climate, there is merit in exploring alternative forms of funding and harnessing Islamic finance could be a source of enormous benefit to the UK as a whole.

‘London is recognised as the international centre for Islamic finance because of our ongoing commitment to policies that will help create a level playing field for both retail and wholesale Islamic finance. This has resulted in the UK becoming the number one jurisdiction in the western world in terms of Shari’ah compliant assets.’ He fell short of giving any indication that the UK government would be reviewing the idea of a UK sovereign sukuk, which will no doubt be a disappointment to Islamic bankers such as Humphrey Percy, CEO of the London based Bank of London and the Middle East, who commented in our January 2013 issue, ‘We do personally feel that we have been left slightly high and dry by the authorities and the political establishment here in that it was indicated quite strongly that there would be a UK government sukuk.’

In early March the UK government followed these expressions of support for Islamic finance with the launch of the UK’s first Islamic Finance Task Force, designed to cement London’s status as the western hub for Islamic finance by supporting the development of the UK’s Islamic finance sector, increasing inward investment and strengthening the economy.

The Task Force will have three key objectives:

• to act as UK Ministerial Champions for the World Islamic Economic Forum in London on 29-31 October 2013;

• to engage with the United Kingdom Islamic Finance Secretariat (UKIFS) and others to promote and raise the international profile of the industry;

• to use Islamic finance to facilitate inward investment and strengthen the UK economy, including ongoing support for Sovereign Wealth Funds looking to invest in UK infrastructure.

The Task Force will be co-chaired by Financial Secretary to the Treasury, Greg Clark and Baroness Warsi, Senior Minister of State at the Foreign and Commonwealth Office. Minister of Trade and Investment, Lord Green and Minister of State for International Development, Alan Duncan will provide additional ministerial support. Key industry figures have agreed to support the Task Force including Richard Thomas, CEO Gatehouse Bank and Chair of the UK Islamic Finance Secretariat; Wayne Evans, Director of International Strategy, TheCityUK, UK Islamic Finance Secretariat; Shabir Randeree, Group Managing Director of DCD London and Mutual PLC; Dr Mohammed Abdel-Haq, CEO of Oakstone Merchant Bank Ltd; Stella

London is recognised as the international centre for Islamic finance

Cox, Managing Director, DDGI/ DDCAP; Richard de Belder, Partner SNR Denton and Mark Boleat, Chairman of the City of London Policy and Resources Committee.

Baroness Warsi commenting on the initiative said, ‘We expect the global market for Islamic financial services to experience significant growth over the coming years, but feedback from decision makers in the Middle East and South East Asia suggests there is a lack of awareness of the UK industry and that we should be doing more to promote the sector. There are also major opportunities to attract investment into the UK as demand for Islamic finance increases from private investors and Sovereign Wealth Funds.’

Again, the announcement fell short of making any commitment to a UK sovereign sukuk.

Kenya Reinsurance Launches Retakaful Window Operation

Kenya Reinsurance Corporation Limited (Kenya Re) has officially launched the Retakaful Window. Although the Corporation has been handling retakaful business over the years, the company was faced with the important decision of whether to become fully Shari’ah compliant through the establishment of a retakaful window or open an independent fully fledged company. Commenting on the decision to open a window operation, Mr. Jadiah Mwarania, Managing Director of Kenya Re said, ‘In Kenya Re’s situation, a window was ideal as it is possible to piggyback on Kenya Re’s resources both the software and the hardware. As the business grows, we may in future consider forming a retakaful reinsurance company.’

He continued, ‘We see this as a huge opportunity as the retakaful business is worth $10 billion worldwide and is growing. As a growth strategy to serve customers in countries beyond Africa, we can’t ignore this business. In Kenya, the Muslim population is substantial and growing. We need to ensure that a retakaful capacity is available not just in Kenya, but in all our existing markets in Africa, the Middle East and Asia.’

Kenya Re has established a Shari’ah Supervisory Board comprising four respected Muslim scholars to monitor and guide the business to ensure that its business complies with Shari’ah rules and principles. One of the ways the reinsurance firm has complied is by banking retakaful money in a separate account, dealing with Shari’ah-compliant banks in Kenya (Gulf African Bank and First Community Bank) and selecting Shari’ah-compliant investment vehicles.

Currently, Kenya Re carries out its reinsurance business in Africa, the Middle East and Asia serving in excess of 170 companies in more than 47 countries. It was established in 1970 through an Act of Parliament and started operations in 1971 with 60% of its equity being owned by the government and the rest held by the public through the Nairobi securities exchange. At end of 2011, the total asset base was over Ksh 21 billion.

NEWHORIZON    April to June 2013 News

Dubai’s Ruler Nails His Colours to the Mast

Sheikh Mohammed bin Rashid al-Maktoum, the ruler of Dubai, has issued a statement indicating his determination to make Dubai Sheikh Mohammed bin Rashid
al-Maktoum a world centre for Islamic finance. Speaking about the Islamic economy, he said, ‘We have a clear vision for this vital sector and we want it to contribute significantly to our national economy and to help bolster our position as the world’s capital for Islamic economy. We have the infrastructure, the strategic location at the heart of the Islamic world and importantly, a vast knowledge and experience in Islamic economy, Islamic banking, Islamic sukuk and insurance, and we have, above all, the resolve and ambition to achieve our goals.’

Certainly Dubai is a very international city, particularly when compared to others in the region; its geographic position at the heart of the Gulf region and the strong connectivity it has established with the rest of the world are helpful and its airport is a major hub for air traffic between Europe, Asia and Africa. On the other hand, while it is currently a major centre for conventional finance in the Gulf, its Islamic financial credentials are eclipsed by other centres such as Malaysia and even Bahrain, which, while it has suffered recently due to civil unrest in the country, will not be happy to sit back and allow Dubai to steal its crown.

As if to underline Dubai’s ambitions, within weeks of this statement, it was announced that Dubai is planning to set up a central Shari’ah board to oversee all Islamic financial products. (Only Malaysia has a similar arrangement.) Eissa Kazim, secretary general of the committee overseeing Dubai’s economic strategy commented, ‘We will harmonise all standards, structures and regulations through having a unified Shari’ah board at a government level to oversee the industry.’ Dubai’s objective is to reduce confusion, make stock exchange listings easier and thereby attract more business.



Growth of Takaful Hampered by Inconsistent Regulation in GCC Countries

While the takaful industry has been developing rapidly in the countries of the Gulf Cooperation Council (GCC), the development of takaful regulation varies significantly country by country and even within countries, with the Qatar and Dubai Financial Centres operating under their own laws rather than the laws of the countries in which they are located. Market participants in some of the more demanding regimes consider the regulations to be stifling their companies. A.M. Best suggests the solution is not less regulation but more consistent application of regulation throughout the region, thus safeguarding the long-term viability of the takaful industry, while providing adequate protection for policy holders. According to the report, there are three key issues that need to be examined to establish an adequate level of policyholder protection:

• Takaful-specific regulation regulation tailored to the demands of the takaful model is important, especially in recognising the existence in takaful of separate funds for policyholders and shareholders. This is a major difference between takaful and traditional insurers and regulation needs to provide the rules under which these funds interact, both during insolvency and when the company is viewed as a going concern.

• The obligation to provide qard hassan at all times based on key principles of the takaful model, operators are obliged to provide a qard hassan (an interest-free loan) to cover any deficits that arise. The principle, however, leaves unclear the permanence of qard hassan because, as a loan, it may need to be repaid to the shareholders when it becomes evident that the takaful fund is not viable over the long term. Regulators are, therefore, called to establish rules of permanence for qard.

• Policyholder priority this is important particularly in cases of insolvency, and in most cases, it is provided by the general law rather than the provisions established by insurance regulators.

NEWHORIZON    Jamatul Thani - Sha’ban 1434 News

In Brief

Dar Al Istithmar, the Islamic advisory firm with offices in London and Dubai has closed. It was set up in 2004 by Deutsche Bank, Oxford Islamic Finance Ltd and Russell Wood Ltd, although Deutsche Bank subsequently withdrew. Company personnel have apparently moved to Khaliji Islamic, also an advisory company with offices in London and Dubai. There has been no official statement about the closure, but it is rumoured the management of the company fell out with shareholders about its future direction.

The Central Bank of Bahrain is apparently drafting new rules for takaful designed to promote the growth of the sector by attracting new operators, particularly international organisations. It is reported that as many as 20 Shari’ah scholars have already signalled their approval for the proposed changes.

The Kuwait Capital Markets Authority has issued an advisory statement warning all Shari’ah compliant financial institutions in Kuwait to ensure that they employ the right number of properly qualified Shari’ah scholars. The statement, however, has no legal or regulatory authority. The statement is believed to be a response to concerns that self regulation by financial institutions is patchy.

Hamkor Bank is pursuing plans to begin offering Islamic banking services in Uzbekistan. They have apparently concluded an agreement with Pakistan’s Al Huda Centre of Islamic Banking and Economics, which will provide Hamkor Bank with consultancy, Shari’ah advisory services and personnel development. There is, however, currently no indication of when Islamic banking services will become available in Uzbekistan.

A recent market research study in Belgium conducted on behalf of the Association for the Development of Islamic Finance (ADEFI) and Islamic Finance Advisory and Assurance Services (IFAAS) suggests that more than 70% of Muslims in Belgium would be likely to take up Islamic banking services if they were on offer. Results are based on 500 interviews carried out with both men and women from a variety of socio economic groups across the country.

Bahrain-based Ithmaar Bank, has received final approval from the Central Bank of Bahrain and the Bahrain Ministry of Commerce and Industry for its merger with First Leasing Bank. The merger raises the bank’s capital to $758 million and also enhances its capital base as well as its capital adequacy ratios. A recent report, published by the Bahrain Bourse, indicates that Ithmaar Bank shares saw more than 160% growth in 2012, despite a 6.83% decline in the Bahrain All Share Index that year. Since Ithmaar Bank’s reorganisation in April 2010 with its then wholly-owned subsidiary, Shamil Bank, and its subsequent transformation from an investment bank into an Islamic retail bank, Ithmaar has focused on developing its retail and commercial banking operations.

Following approval from the Securities and Commodities Authority, Dubai Islamic Bank (DIB) published its formal offer for the shares in Tamweel PJSC it does not currently own. (DIB is the majority shareholder in Tamweel with 58.2% of the issued equity.) The offer was approved by an Extraordinary General Meeting of DIB shareholders in early March. Dr. Adnan Chilwan, Deputy Chief Executive Officer of Dubai Islamic Bank, said: ‘This move reflects DIB’s commitment to supporting the UAE economy in general and the resurgent home finance sector in particular. We believe this offer is in the best interests of the shareholders, customers and stakeholders of both DIB and Tamweel.’

Qatar’s Masraf Al Rayan bank has received the approval of its shareholders to push ahead with the acquisition of a strategic share in a Libyan commercial bank.

Shareholders have given the bank two years and QAR 1 billion to complete the deal. The acquisition will be subject to the satisfactory completion of the due diligence process, which is currently under way and the approval of the relevant authorities in both Qatar and Libya.

Kuwait’s The Investment Dar has sold its 51.6% stake in the Bahrain Islamic Bank to the National Bank of Bahrain and Social Insurance Organisation – Bahrain. The decision comes in the wake of the announcement of 2012 results which revealed that Bahrain Islamic Bank’s losses had more than doubled from BD 17 million in 2011 to BD 36 million in 2012.

Rumours are again circulating that the government of Qatar has imminent plans to set up a large, international, Islamic bank capable of competing with conventional banks on an equal footing. Qatar signed a memorandum of understanding with the Jeddahbased Islamic Development Bank and the Saudi-based Al Baraka Group in April 2012 to establish a bank with initial capital of $1 billion.

In another development involving Qatarglobal news organisations are reporting that former French President, Nicolas Sarkozy has been approached by Qatar’s sovereign wealth fund to head up a private equity fund with initial capital of €500 million. The reports suggest that Mr Sarkozy has not, however, committed himself as yet, because he still has an eye on a political comeback, an idea which has been encouraged by a decline in the popularity of French President, Francois Hollande according to recent polls.

The Moroccan government is planning to submit a bill to parliament to regulate Islamic banks, which will be known as participative banks. In a parallel move the central bank has begun talks with Shari’ah scholars to set up a central Shari’ah board for the country.

BLME reported a return to profit in 2012. Net operating profit rose from £4.4 million in 2011 to £7.3 million in 2012 and with no new impairment changes this produced a profit of £3.8 million compared to a loss of £8.9 million in 2011. The balance sheet grew 29% to more than £1 billion. BLME are bullish about their prospects for 2013 citing the imminent opening of a representative office in Dubai and new product launches as key factors in enabling the bank to expand its reach and distribution.

The Malaysian government is undertaking a review of waqf with a view to allowing them to be run by private corporations rather than religious bodies. The objective is to make waqf more productive. A first study will be published in June with a second to follow in December. It is estimated that only 20% of waqf in Malaysia generate significant revenue although they control land estimated to be worth $384 million.

IFC, a member of the World Bank Group, has announced a $5 million investment in Kenya’s Gulf African Bank to support corporate finance and lending to small and medium businesses in East Africa. The investment in Gulf African Bank marks IFC’s first engagement with an Islamic finance institution in Sub-Saharan Africa. Gulf African Bank, one of Kenya’s only two Islamic banks, has 14 branches in Kenya, offering a range of Shari’ah-compliant banking products and services. In addition to the equity investment, a further $3 million trade line will be made available to Gulf African Bank under IFC’s Global Trade Finance Programme.

AAOIFI and Ernst & Young have signed an agreement to carry out certification of core banking systems for the Islamic finance industry. The certification process will be carried out under the supervision of a committee of Shari’ah scholars drawn from AAOIFI’s standards boards. One of the primary aims will be to encourage providers to incorporate AAOIFI standards into their systems.

Kuwait Finance House Turkey is to increase its capital by TRL960 million in two phases over the next year. The first phase will inject TRL600 million by May 2013 and the second phase a further TRL360 million by May 2014. The move underpins the bank’s ambitions to open a fully-fledged Islamic bank in Germany as well as banks in Bahrain and Dubai.

Saudi Arabia has left the International Islamic Liquidity Management Corporation (IILM). Qatar and Malaysia have acquired Saudi Arabia’s share in IILM. Saudi Arabia’s decision must be something of a disappointment for IILM, which was founded in 2010 and began operations just over two years ago with the aim of helping Islamic banks manage liquidity. It is interesting that IILM replaced Professor Datuk Rifaat as CEO in late 2012 with Mr Mahmoud AbuShamma, which followed two failed attempts to issue a sukuk. Interestingly, within days of Saudi Arabia’s withdrawal from the IILM, the organisation announced they would issue a £500 million sukuk in the second quarter of 2013. It is tempting to speculate whether the conservative central bank of Saudi Arabia was unable to agree with the way the sukuk was being structured and Mr AbuShamma took a harder line on this issue than his predecessor thus triggering the withdrawal. For now everyone is being very tight lipped on the reasons for Saudi Arabia’s withdrawal and whether Saudi Arabia’s withdrawal is likely to affect the acceptability of the forthcoming sukuk.

Richard Thomas OBE is to relinquish his current responsibilities as Chief Executive Officer at Gatehouse Bank to take over a new role with the Bank to spearhead an expansion in its South East Asian operations. Mr Thomas took over as Chief Executive Officer in August 2009 when the Bank was making losses year on year. He was instrumental in turning the bank round, working closely with the bank’s board in establishing the new business model and franchise based on real estate investments and wealth management offerings. Mr Fahed Boodai, Chairman has been appointed as interim Chief Executive Officer.

It is reported that Turkey’s stated owned Ziraat Bank is working towards the establishment of an Islamic banking arm. The move is understood to be an attempt to attract more investment from Asia and the Gulf, as well as to strengthen Turkey’s position in Islamic finance. Currently three of the four Islamic banks in Turkey (known as participation banks) are foreign owned.

DMCC’s Challenge to the London Metal Exchange

Dubai Multi Commodities Centre (DMCC) has announced the inaugural commodity murabaha transaction on its DMCC Tradeflow platform. The transaction took place between Noor Islamic Bank and Commercial Bank of Dubai, marking the official launch of the DMCC Tradeflow Islamic product portfolio. Throughout the development of the platform, DMCC has worked closely with consultancy firm, Dar Al Shari’ah Legal & Financial Consultancy LLC, to ensure that the commodity murabaha mechanism complies with Shari’ah principles. In late 2012 DMCC Tradeflow received a fatwa certifying that its Islamic transactions are fully in accordance with the principles of Shari’ah. The commodities available on DMCC Tradeflow include oil products, foodstuffs and base metals.

DMCC claim that its platform offers ‘stronger’ murabaha, thus responding to the concerns of some scholars who say that commodity murabaha is not sufficiently closely aligned with of some scholars who say that commodity murabaha is not sufficiently closely aligned with real economic activity, i.e. it is often a paper transaction in which no commodities really change hands. DMCC say that their platform tracks the ownership of commodities in such a way that it demonstrates real trades have taken place. DMCC’s Tradeflow is potentially an alternative to the London Metals Exchange, which has dominated the commodity murabaha business to date.

NEWHORIZON    April to June 2013News

SUKUK UPDATE

Sukuk Innovation at Gatehouse Bank

In the wake of the financial crisis bond investors have become more security conscious. This has revived interest in covered bonds, first used in Northern Europe more than 200 years ago, which give investors access to a pool of assets if the issuer of the bond fails. Now, the UK’s Gatehouse Bank, a subsidiary of Farmida Bi `Kuwait’s Securities House, has dipped its toe in the water with a relatively modest, privately placed sukuk that mimics the covered bond structure. The five-year, $10.4 million sukuk uses an ijara structure that gives investors recourse to Gatehouse Bank in addition to security over the sukuk asset, a double layer of security. (Ijara structures do not usually involve transfer of the underlying assets to the investors.)

Commenting on the issue, Farmida Bi, partner and European head of Islamic finance at law firm, Norton Rose, who advised Gatehouse Bank on the issue, said, ‘There has been extensive debate in Islamic finance circles as to whether sukuk need to be asset-based or asset-backed. This structure allows investors to have recourse to the originator pursuant to the purchase undertaking but, in the event of a shortfall, the investors are entitled to enforce their rights against the underlying asset.

‘Covered bonds have become a very popular means of financing since the global financial crisis. The availability of a Shari’ah - compliant form of this structure has been watched keenly by the market. This deal demonstrates that sukuk issuers are continuing to innovate and respond to investor demand. The deal also demonstrates that Islamic finance remains buoyant and active in the UK and is providing a source of liquidity at a time when conventional liquidity remains constrained.’

Investors do, of course, pay for this extra security in that returns on the investment are typically lower. Some investors such as pension funds may, however, be willing to accept a lower rate as the regulatory environment around the safeguarding of such funds becomes ever more stringent. It has also been suggested that ‘covered sukuk’ could be useful as tradable Islamic money market instruments, which are currently in rather short supply. It will be interesting to see if any other issuers decide to adopt this approach.

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HSBC Amanah Forecast Another Record-Breaking Year for Sukuk

HSBC Amanah, who were apparently the biggest underwriter of sukuk in 2012, knocking Malaysia’s CIMB off the top spot, has suggested that 2013 will be another record-breaking year. In the GCC alone they anticipate sukuk sales growth of 64%, up to between $30 billion and $35 billion. They also expect Turkey, Indonesia, Hong Kong and Australia to contribute significantly towards the growth of sukuk and are forecasting a total market size of between $55 billion and $60 billion. This forecast is despite a slow start to the year with issuance down 20% in the first 6 8 weeks of 2013 according to figures from Bloomberg. The only development that could rain on this parade is if there is a ‘broader weakening of the fixed-income market’, according to Mohammed Dawood, Managing Director of HSBC Amanah’s Dubai-based debt capital markets operation.

Australian Joint Venture Opts for Sukuk

SGI-Mitabu is a joint venture company formed by two Australian organisations, The Solar Guys International and Mitabu Australia. They have chosen to finance the development of 250 megawatt solar power project in Indonesia with an istisna sukuk. The first tranche of the sukuk designed to meet project construction costs is worth A$100 million and will be domiciled in Labuan, Malaysia’s offshore financial centre and targeted primarily at Malaysian investors. It is expected to be followed by further sukuk to meet the full cost of the project which is estimated to be A$550 million. The initial seven-year sukuk anticipates paying between 6.5 - 7.5% returns.

Success for Malaysia’s First Retail Sukuk

Sukuk have mainly been the preserve of the big institutional investors, but recent developments in Malaysia have opened the door to retail sukuk designed to be available to smaller investors either through the stock exchange or over the counter at banks. The first sukuk to be issued in this format came from DanaInfra Nasional, part of the Finance Ministry. It was designed to provide part of the funding for Malaysia’s mass rapid transport project, which will cost MYR 23 billion in total. The MYR 300 million sukuk was 0.61 times oversubscribed.

Sukuk Performance and Forecasts

Sukuk issuance grew by 54% in 2012 compared to 2011 with the Malaysian ringgit continuing to dominate the market accounting for 74% of all primary market sukuk issuances. KFH said the sukuk market was worth $131 billion in 2012. (The sukuk market has grown by an annual compound rate of nearly 68% since the global financial crisis of 2008.) They predict growth for 2013 of 20 30%.

A report from Standard & Poors (S&P) suggested that 2012 growth had been slightly higher at 64% producing $138 million. S&P forecast further growth for the market, but fell short of predicting just how large that growth would be.

IILM Close to Issuing First Sukuk

After falling at the final hurdle twice the International Islamic Liquidity Management Corporation (IILM) is very close to issuing its first sukuk according to the governor of Malaysia’s central bank, Zeti Akhtar Aziz. The problems in the past have been making sure that any sukuk complies with the laws of all 12 member countries. In mid March she said that an announcement would be forthcoming ‘in the near term’. It has been suggested the sukuk will be worth between $300million and $500 million.

The IILM face a tricky task in getting the terms of the sukuk right. To fulfil their aim of boosting short-term liquidity in the Islamic finance industry the offer needs to be sufficiently attractive to encourage investors, but at the same time not so attractive that these investors buy to hold.

Dubai Sees Strong Sukuk Activity

The UAE’s Emirates airline $1 billion sukuk was three times oversubscribed when it listed in mid- March on the Nasdaq Dubai exchange. Investors were mainly from the MENA region (85%) with 7% from Europe, 5% from South East Asia and 3% from the US. This followed another $1 billion sukuk from the Dubai Electricity and Water Authority (DEWA) in early March. A further $1 billion sukuk expected to list in Dubai in the near future is from the Dubai Islamic Bank, with sukuk of the same size expected from the Etisalat Sukuk Company and Al Hilal Bank later this year. This activity will no doubt please Nasdaq Dubai, which has stated its intention to become the largest exchange in the world for sukuk by listed value.

Qatar to Issue Regular Sukuk

In March Qatar’s central bank announced that it would be be selling quarterly bonds and sukuk. The three and five year instruments will have a value of QR4 billion ($1.1 billion). The division between bonds and suluk will be QR3 billion of the former and QR1 billion of the latter. The sale is designed to help banks meet Basel III capital requirements. It is also hoped that it will help Qatar develop a yield curve to allow Qatari companies to borrow at a lower cost.

Second Project Finance Sukuk in Saudi Arabia

The Sadara Chemical Company (a joint venture between Saudi Aramco and Dow Chemicals) has raised 7.5 billion riyals from the sale of 16 - year sukuk to fund the construction of a major petrochemical facility at Jubail. The original target of 5.25 billion riyals was increased due to very strong demand from Saudi investors. The amount raised was double the 3.75 billion riyals raised by Saudi Arabia’s first project finance sukuk in late 2011.

Morocco and Tunisia Contemplate Sukuk Issuance

Both Morocco and Tunisia have said that they may issue sukuk in mid 2013 to address budget deficits. Morocco has not yet decided whether they will raise money through a conventional bond or a sukuk. A decision is expected in July. Tunisia’s plans appear to be more definite. They say they will issue a sovereign sukuk to raise $700 million dollars in July.

Sharjah Islamic Bank’s Sukuk Six Times Oversubscribed

Sharjah Islamic Bank’s (SIB) $500 million, five-year sukuk was six times oversubscribed when it listed in mid April. Investors came from the MENA region (53%), Asia (30%) and Europe (17%). It lifted the total value of sukuk listed on the Dubai Exchange to $12.125 billion, the third largest total in the world. This initial issue from SIB is part of a $1.5 billion programme.

Insurance Policy for Sovereign Sukuk

The Islamic Corporation for Insurance of Investment and Export Credit (ICIEC) an arm of the Saudi-based Islamic Development Bank (IDB) has announced the Sovereign Sukuk Insurance Policy, which will become available later in 2013. This instrument will provide protection to sukuk investors in the event of a default on sovereign sukuk issued by any IDB member country. Initially the policy will cover ijarah sukuk and later roll out to include other forms of sukuk. The objective is to help promote infrastructure development, particularly in those countries which are rated below investment grade or have no rating, by encouraging international banks and investors to participate in such sukuk offerings.

QIB Launch International Sukuk Portfolio

QIB’s International Sukuk Portfolio launched in April 2013 aims to introduce a broader range of investors to what it describes as the long-neglected sukuk class of investments. The portfolio will invest in sovereign, quasi-sovereign and corporate sukuk and will be managed by a team from QIB UK, which has considerable experience in asset management. (QIB UK currently manages one of the largest sukuk funds with $220 million in assets under management, delivering 30% returns consistently since it was launched in 2009.) The Fund will concentrate on income with some capital appreciation.

Innovative Sukuk in Turkey

International legal practice Norton Rose has advised Türkiye Finans on their debut sukuk issuance of US$500 million, the first non-ijarah sukuk issued out of the country. Alex Roussos, Of counsel, commented, ‘This was a complex transaction as we had to fully explore the capital markets and tax regimes in Turkey and its implications for our client. The sukuk involved a hybrid structure using a pool of lease assets combined with a series of murabaha trades. This transaction paves the way for hybrid, innovative structures in the Turkish marketplace, which is further evidence of the growing sophistication of that jurisdiction and the very vibrant and dynamic nature of market participants there.’

The five-year sukuk was 3.8 times oversubscribed. The majority of investors (51%) came from the Middle East with 17% from continental Europe, 15% from the United Kingdom and 17% from the Far East.

Osun State Expected to Issue Nigeria’s First Sukuk

In June Reuters reported that Nigeria’s Osun State, a centre of cocoa production, plans to issue Nigeria’s first sukuk, starting with 10 billion naira ($62 million) before the end of July. The planned seven year paper is part of a 60 billion naira debt raising programme by Osun State and will be used to finance the construction of educational facilities. The ijara sukuk will be issued through a book-building process and will pay returns on a twice-yearly basis. It will target both local pension funds and international investors. In June Osun State was awaiting approval from the Securities and Exchange Commission (SEC) approval to start marketing the bond. (In March, Nigeria’s SEC approved new rules allowing firms to issue Islamic bonds, a move aimed at attracting Middle Eastern investors.) The note will be listed on the Nigerian Stock Exchange.

NEWHORIZON    Jamatul Thani - Sha’ban 1434POINT OF VIEW

Sequelae of the Dow Jones Fatwa and Evolution in Islamic Finance:The Real Estate Investment Example

Michael J.T. McMillen

This article derives from a presentation made by the author at the 4th Annual IIBI-ISRA International Thematic Workshop. That presentation focused on evolutionary developments in Islamic finance since 1998. Specifically, it considered certain concepts that were institutionalised in the 1998 fatwa (the “DJIMI Fatwa”) issued to Dow Jones Islamic Market Indexes (‘Dow Jones) in respect of equity indices: permissible variance; purification; and core business activities. The presentation outlined how the interpretation of those principles has evolved and noted some of the ramifications of that evolutionary process (including governance issues).

Conceptual evolution occurred first within the field of equity investing as tests were refined and modified. Subsequently, those concepts were applied and developed in other areas of Islamic finance, such as private equity and real estate investments, project and infrastructure financing and the finance side of the Islamic capital markets (i.e., sukuk). This article considers examples of how those concepts were applied and have developed in the real estate investment context.

That evolutionary process was (and remains) quite similar to the development of Anglo-American common law: case-by-case determinations, modifications, extensions, refinements, re-evaluations and reconsiderations. During the period from 1998 to the present, that process was notably accelerated and condensed due to the extraordinary growth of Islamic finance during this period.

Dow Jones Fatwa

In 1998, after five years of deliberation, the Dow Jones Shari’ah Board issued the DJIMI Fatwa, which must be regarded as one of the more monumental fatwa in the history of modern Islamic finance. It was issued in the context of the development of indices for Shari’ah-compliant equity securities. It considered, specifically, the criteria for inclusion or exclusion of an equity security in those indices. Considered from a slightly different vantage, the context was equity investing and, specifically, when and under what circumstances a non-controlling investment could be made in equity securities of an entity when that entity had some degree of (i) impermissible interest income or expense and/or (ii) engagement in an impermissible business activity.

It was clear to the Shari’ah Board that an Islamic equity index and investments in equity securities were not possible if the applicable criteria preclude, as an absolute matter, investment in a company that has any interest income or expense, direct or indirect, or engages in any impermissible business activity. Virtually every company had some degree of impermissible interest income or expense, primarily as a result of direct or indirect deposits, investments or indebtedness. Some companies engaged primarily in permissible business activities, but had limited involvement in impermissible business activities. Consider, as examples, an automobile and truck manufacturing company that also owned a credit company that financed purchases of its vehicles, a grocery purveyor that sold pork products or beer, or the business composition of various multinational conglomerates. The question, generally posed, was whether the Shari’ah was absolutely preclusive and intolerant of even slight impurities. The debate was, and remains, spirited.

The DJIMI Fatwa established a framework, a series of tests, for addressing these issues. These tests acknowledged, and sanctioned, on a conditional and temporary basis, a degree of variance from or impurity relative to absolutist concepts. An investment could be made in the equities of a company with a limited amount of impurity. That recognition led to the institutionalisation of various ‘cleansing’ or ‘purification’ mechanisms that are operative upon and after the occurrence of the equity investment and are designed to address subsequent impure consequences (e.g., interest income, which is cleansed through donation to charity).

The DJIMI Fatwa established two sets of tests to determine the permissibility of the equity investment (see Figure 1). The first test had two branches: (a) whether the subject security is itself impermissible because, say, it is a fixed income instrument (such as preferred stock) with an impermissibly stipulated or guaranteed return; and (b) whether the ‘core’ business of the subject entity (as opposed to ‘any’ business) is halal and impermissible (because it entails dealings in alcohol, tobacco, pork products, interestbased financial services, non-takaful insurance, defence and weapons, casinos/gambling, pornography, or other inappropriate elements). If those threshold tests do not preclude investment, the inquiry turns to whether the entity has an impermissible degree of riba or haram income as determined pursuant to a series of financial tests that are summarised in Figure 1.

But is helping create more jobs a social responsibility of for-profit, shareholder-owned institutions offering Islamic financial services? Or, does this responsibility only belong to others, such as governments and development finance institutions?

The DJIMI Fatwa institutionalised the principle that some degree of impermissibility or impurity is permitted in defined circumstances: an entity may have a degree of interest income or expense, for example. However, that impurity must be ‘cleansed’ or ‘purified’ where possible.

Will the rise of Islamic
finance address the
problem of high unemployment
among the Arab youth?

The basis for evolution and development of the variance, purification and core business concepts was laid down in the DJIMI Fatwa itself. The DJIMI Fatwa mandated a periodic and continuous review process to ensure ongoing compliance and, in connection with each financial test, emphasised that more precise tests must be adopted if they become available and that Shari’ah compliance must be measured using the most accurate tests available from time to time.

Evolutionary Application in Real Estate Investing

To set the stage for examining the evolution of the DJIMI Fatwa concepts, the basic principles are that (a) tenants in a building owned or controlled by a Shari’ah-compliant company cannot conduct business activities that are not compliant with the Shari’ah and (b) the occupational tenant leases for that building must be Shari’ah compliant. The tenant business activities requirement profoundly influenced the development of Shari’ahcompliant real estate investments in the early years. Thus, for example, from 1998 to 2002 the focus was on investments in residential properties, in part because this eliminated the need to test tenant business activities (and in part because of the growth in the residential property markets at the time). The business activities requirement was also a strong influence in shaping the first Shari’ah-compliant commercial real estate funds around 2000-2002. In the early years, those funds focused on single tenant properties so as to minimise business activities concerns and associated due diligence costs.

As the Shari’ah-compliant real estate sector began to grow (and it grew rapidly), and began to focus on multi-tenant and mixed use properties, there was progressive implementation, and evolution, of the permissible variance, cleansing and core business concepts in two areas: tenant business activities analysis; and tenant lease analysis. This occurred in three situations: (a) a compliant business activity conducted by the tenant at the leased property where that tenant, as a larger entity, also conducted non-compliant business activities at other locations; (b) a non-compliant activity conducted at the leased property; and (c) non-compliant tenant leases for the leased property. In this context, it is important to note that the DJIMI Fatwa and subsequent fatwa have focused on the ‘core’ business activities tests rather than each and every business activity of a prospective tenant: the business activities at the property must be Shari’ah compliant, at least to the extent of the permissible variance parameters, and the ‘core’ business of the tenant and its corporate group must be in compliant activities. Purification and cleansing tests have been utilised to address allowable impermissible non-interest business activity income derived from real estate investments, with an outside tolerance collar (of, say, 5%).

An early example of non-compliant activity involved the acquisition of a large commercial property that had only one non-compliant tenant, an automatic teller machine (ATM) owned and operated by an interestbased bank. The relevant Shari’ah Board undertook a careful factual inquiry and determined that, among other factors, the square footage and proportionate rent of the ATM space was minimal relative to the entirety, there were no Islamic banks as alternatives, and the business conducted at the ATM was primarily non-commercial. The acquisition of the building and the presence of the ATM, were permitted. The number and variety of scenarios involving non-compliant tenants expanded quickly and commensurately with the expansion of Shari’ah-compliant real estate investments. Consider, as examples, supermarkets selling pork and/or alcohol products, restaurants serving alcohol, the check clearing operations of an interest-based bank, and the back-office operations of insurance companies as but a few of the myriad of factual scenarios that have been considered.

Shari’ah Boards have addressed these matters on a case-by-case basis with close examination of the precise facts. While generalisations are difficult, and of uneven application, some of the factors that may be relevant in such an inquiry include: the nature of the non-compliant business; the square footage of the noncompliant rental unit and its relative relationship to the square footage of the entire property; the amount of rent derived from the space in which the non-compliant activity is conducted and its relationship to the total property rent; whether the activity is an essential or elective service; if it is an elective service, its relative importance to the property; the tenant population and the surrounding community; whether the business serves a commercial or a residential client base; the availability of equivalent or complimentary services in the immediate and broader vicinity; and constraints imposed by geographical and national circumstances.

These issues can be quite complex and are heavily dependent upon the specific facts of each case. For example, in one case it was necessary to do time-transportation studies to determine whether employees of an office park had any lunch-time alternatives to the restaurants in the acquired office park, which served alcohol. For example, all restaurants in the surrounding area were identified, and travel times to and from those restaurants during the lunch hour were established. It was determined that there were very few accessible restaurants outside the office park and that it was difficult (if not impossible) for people working in the office park to eat at restaurants outside the office park given lunch hour time constraints. Studies were also done of the amount of alcohol served by restaurants of this type in this type of location at different times of the day and night, and of the amount of profit generated from alcohol sales and food sales, respectively, for restaurants of this type and at this type of location. As the restaurants would not provide specific information and data, industry information and data were obtained from trade groups and other sources. Based upon the particular facts of this unique situation, the relevant Shari’ah Board ultimately approved the acquisition of the building containing the restaurant, but imposed a range of conditions on the acquisition and subsequent activities. For example, and as one of numerous conditions, a portion of the rent paid by the restaurant must be donated to charity as cleansing. And, in some circumstances, a non-compliant tenant may have to be removed upon expiration of the term of the lease in effect at the time of acquisition of the property.

A second area in which the DJIMI Fatwa concepts have been applied and developed involves noncompliant occupational tenant leases. Experience indicates that approximately one-half of the tenant leases in effect at the time of the acquisition of a commercial property are not Shari’ah compliant. Frequently, this is because of the existence of default or late payment interest provisions. In other cases, noncompliance relates to requirements that the tenant perform structural maintenance (as a result of the market prevalence of ‘triple-net leasing’ concepts). In still other cases, the lease may require the occupational tenant to maintain casualty insurance, a correlative of the structural maintenance requirements. There are a range of other reasons for noncompliance.

Late payment and default interest provisions are sometimes preserved where there is a desire to incentivise timely payment. Purification is then effected by donating the interest payment to charity. Given broader market practices and standardisation, it is virtually impossible to change some of the other offensive provisions (such as structural maintenance and casualty insurance obligations). Shari’ah scholars have been pragmatic and sensitive in addressing these issues. For example, many scholars permit the property acquisition despite the existing non-compliant leases, but require that a reasonable attempt be made to bring that lease into compliance if that can be accomplished at a reasonable cost and without disruption of the tenant relationship. Thereafter, other efforts must be made to bring the non-compliant tenant leases into compliance. For example, upon elective or permissive renewal of the occupational tenant lease, that lease will have to be made compliant.

Conclusion

Modern Islamic finance is a dynamic industry that has developed rapidly since the mid- 1990s. One of the most important impetuses to the development and growth of the industry has been the set of concepts that were institutionalised in the DJIMI Fatwa. Those concepts, in turn, have also evolved since 1998. The initial stages of that conceptual evolution were to the tests applied in the equity investing and equity indices contexts. Soon after 1998, however, conceptual evolution took the form of applying the permissible variance, cleansing and core business concepts to other areas of finance and investment. This article notes two such aspects of this evolutionary expansion in the field of real estate investment.

The industry is still in the early stages of its growth: its infancy. Further evolution of these concepts is a certainty. That was intended at the time that the concepts were first effectuated – in order to permit the Islamic finance industry to develop and grow in a world that is dominated by interest-based institutions and practices. However, that evolutionary process was, and is, self-restricted: these variances were created as temporary expedients that are to be replaced by more precise methods as those become available. Thus, from inception there has been a dynamic tension between appropriate evolutionary expansion and growth of the concepts and progressive restriction, to the eventual point of elimination, of those same concepts. Few progressions are as challenging or as interesting.

© Michael J.T. McMillen; all rights reserved.

Yusuf DeLorenzo

Michael J.T. McMillen is a partner of Curtis, Mallet-Prevost, Colt & Mosle LLP. He teaches Islamic finance at the University of Pennsylvania Law School and the Wharton School of Business, among other institutions. He has twice served as Chair (and was the founding Chair) of the Islamic Finance Section of the International Law Section of the American Bar Association.

NEWHORIZON    April to June 2013ANALYSIS

The Subprime Crisis and the Lessons for the Islamic Finance Industry

Suleman Muhammad Ali, Manager- Product Structuring & Research; Product Development and Shar’iah Compliance, Meezan Bank Limited

Background

The subprime mortgage crisis is ongoing. It started in the United States and was characterised among other things by evaporating liquidity in the world’s credit markets, declining asset prices especially in the housing sector, high rates of foreclosures on mortgage assets and the failure of mortgage-backed securities. Although the crisis started in the United States its effects have been contagious and have extended to other financial markets around the globe.

Factors Leading to the Financial Crisis

The crisis started when the US housing asset price bubble started to burst. US housing asset prices had risen sharply during the five years up to 2006. During the period of the bubble more and more people were encouraged to borrow money at low interest rates by various financial institutions. Adjustable Rate Mortgages (ARM) were offered by numerous banks under which mortgage loans were available at very low initial interest rates, with a pre-agreed increase after a certain period, for instance after two to three years. Similarly mortgage loans were offered on very easy terms or with minimal credit appraisal requirements often flouting the process of adequately checking the assets or the existing/ future income streams of the borrowers. All of these efforts were geared towards encouraging more and more borrowing to acquire residential property.

The High Consumption Mindset

Similarly the long-term trend of rising prices encouraged more and more home owners to use the increased value of their homes as security for getting a second mortgage or credit for financing their consumption expenditures or for financing investments in the stock market. In 2008 the average US household debt was around 134% of disposable income and the total nationwide household debt was $14.5 trillion according to US government statistics. All these figures show that the average American was consuming more than he or she was earning. How is it possible for anyone to spend more than they are earning? The answer lies in incurring debt to finance consumption expenditure. All this was due to low credit rates, easy or zero-credit application terms and the increasing value of the underlying mortgaged assets.

Bad Credit Practices and Subprime Lending

In the years leading up to the crisis the US economy had seen unprecedented growth, which in turn resulted in high capital inflows from the growing economies of Asia and from elsewhere around the world as the US was seen as a safe haven for investment. The money that was coming in resulted in a high supply of liquidity. This coupled with lower interest rates and the high rate of origination of mortgage-backed securities produced a mindset in which banks were more eager to service large volumes of credit applications in shorter time spans rather than focusing on ensuring the quality of the credit. The result was the emergence of various schemes allowing credit to individuals with an impaired or no credit history. Automated credit application schemes based on concepts such as NINA (No Income No Assets) basically allowed borrowers to apply for and get credit without showing any proof of employment or assets. Credit was, therefore, given without taking into consideration the ability of the borrower to make repayments. This was also partly prompted by the greed and short sightedness of those bank managers, who were keen to inflate their performance by showing high credit disbursements in the hope of getting short-term benefits and high-performance bonuses.

The Case of Mortgage-Backed Securities (MBS)

Mortgage-backed securities are underpinned by the earnings or the cash flows from various mortgage loans. The payment, return and the security are all tied up in these mortgage loans. It is a product created through modern financial engineering, which allows various banks to pass on their credit exposures to other banks and financial institutions or individuals by repackaging the original mortgage loans into securities or bonds representing an ownership or security interest in these mortgage loans. The previous mortgage or lending model envisaged that the banks originating the loans would hold on to them until maturity; however, with the engineering of securitisation, banks were able to originate and distribute the loans to other entities by repackaging them into securities.

This had two detrimental effects on the US financial market. Firstly it resulted in the availability of excess liquidity to the credit markets. Banks were able to originate the loans through their deposits and then sell these loans throughout the world by repackaging them into securities thereby releasing the liquidity tied up in the original loans to finance yet further mortgages and loans.

Secondly the policy of originate and distribute led to the moral hazard problem and encouraged the banks and investment banks to originate high volumes of mortgage loans with little emphasis on the credit quality of such loans since their focus was short term in nature, i.e. to earn large profits through origination fees; fees for structuring complex mortgagebacked securities and profits from the sale of such securities. These banks and investment banks were not concerned about the longterm quality and results of such securities or the defaults that would arise if housing prices started to fall. The structuring managers were appraised and were paid substantial bonuses on the basis of the various complex securitisation structures of MBS that they were able to sell successfully and the amount of origination of mortgage loans done by the bank managers.

MBS and the Role of Investment Banks

Apart from the moral hazard issues mentioned above; investment banks such as Bear Sterns and Lehman Brothers were not subject to the regulations created for conventional banks. These investment banks borrowed hefty sums of money at low interest rates from the shortterm interbank market and invested them in high-earning, long-term assets such as mortgage-backed securities. Since these investment banks are not allowed to fund their liquidity requirements through the low-cost deposits from retail consumers in the form of current and savings accounts, they normally rely on the issuance of bonds or securitisation of their originated assets to fund these requirements.

Prior to the crisis, however, the major investment banks pursued a policy of making quick profits by borrowing short term at a lower interest rate and investing the proceeds at a higher interest rate thereby producing financial leverage. Most of the low-cost, borrowed money ended up in investments in long-term, highyield mortgage backed securities. Such investment strategies were effective and yielded high profits as long as there were no defaults on the high-yield, mortgage-backed securities, housing prices remained high and credit was easily available from the wholesale markets at lower rates.

By following this policy many investment banks had indulged in excess leverage since the required capital adequacy standards applicable to conventional banks were not applicable in their case. In parallel many conventional banks in the US as well as in Europe used financial innovations such as Special Purpose Vehicles (SPVs) to avoid financial regulation and create mortgage-back securities, transferring there risky assets to the SPV and issuing mortgage-backed securities thereby creating room on their balance sheets for more leverage, which would otherwise have been restricted due to the prevailing capital adequacy standards.

Naked Credit Default Swaps (CDS)

A CDS in its simplest form is a type of credit insurance contract under which a creditor or bondholder buys protection against credit default from an entity selling credit protection or insurance for an agreed fee or premium. In the case of a bond issuing entity or a debtor defaulting on the debt, the protection seller refunds the par value of the bond to the protection buyer. The mechanism of the bond seems to be harmless in this simplest form, however these swap instruments were also being used as a speculative vehicle by investors not holding any bonds. These investors were betting on whether a particular creditor or bond-issuing entity would default or not; hence for a single debt obligation insurance companies issued numerous naked CDS to speculators who did not hold the actual bond issued. When the market collapsed and the defaults started; people began investing more heavily in naked CDS hoping to win the debt in the case of a default. Increasing defaults caused a strain on insurance companies such as AIG who were not able to honour their insurance commitments to a large volume of investors making a claim. This forced the US government to announce a relief package for AIG, since its failure would have caused widespread losses in the financial system due to systemic risk.

Speculative Housing Investments

With the constant increase in housing prices over the long term, housing assets were largely being sought as effective and high-yielding investment avenues. According to certain reports nearly 40% of house purchases in 2005 were not made by primary purchasers who required a home. This led to a further increase in demand, thereby increasing house prices even further.

Underlying Assumptions

All these factors and the behaviour of various stakeholders were based on the following assumptions as described by Warren Buffet; a renowned US investor, industrialist and CEO of Berkshire Hathaway in a Reuters article in 2009:

1. Housing prices would not fall dramatically.

2. Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses.

3. Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk.

4. Economic imbalances, such as large trade deficits and low savings rates indicative of over consumption, were sustainable.

5. Stronger regulation of the non-banking financial system and derivatives markets was not needed.

The Bubble Bursts

The prevalence of the above assumptions, the increase in demand for housing and the cheap supply of credit resulted in a boom in the construction industry to increase the supply of housing to meet the demand. The increase in supply, however, resulted in a decrease in prices at the start of 2006. With this decrease in prices the housing market lost its sparkle as a speculative investment and the speculative investors started to withdraw from the market by selling their long positions. This resulted in a further increase in the supply of homes to be sold in the market. This factor along with the boom in construction resulted in high numbers of houses remaining unsold in the market, thereby further depressing the price of homes throughout the US economy, although the fall in prices was far higher in some states than others. This decrease in price was coupled with the increasing interest rates applicable to mortgage loans after the initial lower rates under the Adjustable Rate Mortgage (ARM) schemes expired. This meant that people with lower or subprime credit ratings started to default on their periodic mortgage payments.

Individuals who had availed themselves of such financing with the idea that they would be able to refinance their ARM loans at lower rates were not able to do so once the underlying housing assets started diminishing in value. As a result there were foreclosures on mortgages with subprime or no credit history and this resulted in more properties available for sale in the economy thereby further decreasing the prices of real estate.

With the decreasing value of houses, defaults in periodic payments by mortgage borrowers and the diminishing values of the underlying mortgage/security; the mortgage-backed securities, whose underlying values were directly related to the cash flows of these mortgaged assets, started to feel the pinch of the housing bubble bursting. The value of MBS started to fall along with the periodic profit payments and the redemption value. The investment banks which had invested heavily in these instruments by borrowing extensively from the short-term interbank market or through the issuance of bonds were unable to fulfil their repayment requirements under these obligations when they fell due. The liquidity position of investment banks was completely compromised. They were unable to sell their long-term MBS assets in the market due to the collapse in the mortgage market; they were unable to generate enough liquidity through borrowing due to their constantly decaying credit standing and the cautious approach of the other lenders and they were unable to generate liquidity through further securitisations.

NEWHORIZON    Jamatul Thani - Sha’ban 1434ANALYSIS

As a result such investment banks and those non-banking financial institutions that had played a major role in swamping the market with excess liquidity completely ran out of resources to generate further liquidity. This in turn resulted in a shortage of liquidity in the market thereby pushing interest rates upwards. With interest rates pushing upwards, housing prices fell more sharply due to the tendency of assets to move in the opposite direction from interest rates. This further resulted in mortgage borrowers being unable to get planned refinancing; the higher rates also resulted in higher profit payments on the loan. The decrease in pricing of homes resulted in home owners falling into the negative equity trap, i.e. the value of the underlying asset financed by the loan is less than the amount of the loan outstanding. This situation resulted in home owners defaulting on the loans since the loans were limited recourse mortgages under which the liability of the borrower is restricted to the enforcement value of the security.

The crisis resulted in a vicious circle in which the fall in house prices led to payment defaults on the mortgage loans thus diminishing the value of MBS. That further decreased the availability of credit in the market resulting in further defaults and foreclosures. Ultimately this resulted in a decrease in housing prices due to an increase in the supply of unsold housing units, which in turn further dampened the availability of credit and the values of MBS and mortgage loans.

Since the world’s financial markets are more integrated than in the past and many financial institutions around the world had invested in the US MBS, the fallout from this crisis engulfed financial markets around the globe especially Western Europe where Iceland teetered on the verge of bankruptcy due to high exposure to US MBS and there was a run on Northern Rock, a British bank, which was eventually nationalised by the British government.

Lessons for Islamic Financial Industry

The Islamic finance industry (IFI) and its players including the regulators need to learn important lessons from the subprime crisis, especially since the industry at present is in its infancy and is indirectly linked to the global conventional financial system.

Limited Recourse Financing and Shari’ah Compliance

One of the main factors that encouraged mortgage borrowers to default on their loans during the subprime crisis was the limited recourse nature of the financing provided by the banks. This meant that once the value of the underlying asset decreased below the value of the loan the customer was better off handing the asset back to the financier rather than make payments for a house, which was worth less than the loan. Under Shari’ah this form of financing in which the debt obligations are restricted to the realisation of the security is not appropriate according to some scholars, since under Shari’ah there are references that individuals are obligated for their debts even upon their death which are to be settled from the property they leave. The division of the estate to the heirs is secondary and is made after debts have been settled. There are quotes that state that a person will be liable for unpaid debts till the Day of Judgment. Restricting debt obligations to the amount of the security by putting such a condition on a sale or a murabaha contract is a void condition and contrary to the principles of Shari’ah.

Islamic financial institutions, therefore, would most likely be exempt from such conditions if their contracts have gone through the required Shari’ah screening. This plus point, however, is only applicable where the transactions involve a debt obligation, for instance a murabaha contract. In cases where the contract does not involve a debt obligation, e.g. ijarah, musharakah mutnaqissa, musharakah or mudarabah, then as per the rules of Shari’ah the underlying contract by its nature only allows a limited recourse to the financier. For these contracts Islamic banks and financial institutions need to build appropriate mechanisms into the contract preventing customers from taking advantage of this limited recourse and discouraging them from defaulting on the debt or removing the moral hazard situation. In certain circumstance the concept of wa’d (undertaking), an appropriate Shari’ah-compliant mechanism, can be used to incorporate appropriate clauses, such as the charity clause, which can deal with the issue of moral hazard at the client’s end. The IFI and its players, therefore, need to revisit their contracts and legal agreements and re-engineer them to safeguard their interests in a manner which is also compliant with Shari’ah.

Diversification of the Asset Base

Another major contributing factor to the collapse of various financial institutions during the crisis was the fact that these institutions had invested heavily in the mortgage market either through direct credit disbursements or through investing in MBS or both. The underlying assumption for this behaviour was the belief that housing prices would not fall over the long term. This belief flew in the face of the age-old risk management lesson ‘do not put all your eggs in one basket’ and once the housing market did fall the financial institutions were heavily exposed to one sector. As a lesson the IFI and its players must diversify their asset base across sectors and industries so that a reversal in one sector does not affect the overall health of any given institution and it is able to survive the losses by banking on its other assets.

Diversification of the Funding Sources

Similarly funding sources should be diversified not only for the Islamic non-banking financial institutions, but also for Islamic banks; since, as the crisis has shown, some institutions had relied very heavily on wholesale sources or the short-term interbank market to get cheap funding. The failure of Northern Rock is a classic case of limited funding sources. The bank relied heavily on the wholesale and money markets for generating liquidity. (About 75 % of their total funding came from this source.) Since the bank was in a high growth mode, increasing its market share in 2007 to 18.9% in the mortgage market from 14.5%, reliance on this mode of funding increased. The bank had changed its funding strategy from ‘originate to hold’ to ‘originate to distribute’ by packaging a pool of mortgage loans and selling the securities to other investors, thereby creating instant liquidity for the bank. This process of securitisation was done through an independent special purpose vehicle (SPV) called ‘Granite’, which issued these securities, thereby enabling Northern Rock to manage its risk by passing it on to the SPV.

Similarly the wholesale funding also included the direct issuance of bonds against the security of mortgage loans without involving the SPV and in this case the risk remained with Northern Rock. Other sources of wholesale borrowing were the interbank money market for mainly short-term funding. While the bank was in a high-growth mode and increased its funding from the wholesale markets to finance that growth, the bank continued to decrease its reliance on retail funding sources. The proportion of deposit and retail funds to the total liabilities and equity of Northern Rock fell from 62.7 % in 1997 to 22.4 % in 2006 according to the House of Commons Treasury Select Committee. This was not only a massive decrease in itself, but also when compared to that of other banks. These figures show the extent of the increasing reliance that the bank was placing on wholesale sources of funding. This strategy of high, expansionary growth through increasing reliance on wholesale markets had the potential to lead to a severe crisis once there was a liquidity shortage in these markets. That is just how things turned out when the US mortgage markets hit troubled waters due to defaults and foreclosures in the subprime mortgage market. Increasingly the wholesale institutional investors became averse to investing in the mortgage-based sector.

Generally, against the backdrop of concerns regarding the slowdown in the US economy due to the subprime mortgage crisis, the confidence of lenders in the wholesale and money markets was low and unfavourable to taking big exposures, especially in institutions heavily reliant upon mortgage assets. The result was the failure of Northern Rock’s funding policy of generating sufficient liquidity at competitive prices. The availability of a healthy level of retail deposits or a retail-fundingoriented policy would have helped the bank weather the crisis in which almost all banks were feeling the liquidity pinch. This is particularly true in the case of Northern Rock, which always had sufficient assets to cover its liabilities, but found it hard to convert its assets to generate liquidity, since they were largely based on declining quality mortgages. Banks with high levels of retail funding were able to survive the storm.

Relying too heavily on retail deposits such as current accounts and savings deposits, however, is an equally bad strategy, since these deposits normally do not have any restrictions on withdrawals by customers. The lesson is clear – the Islamic finance industry and its players need to maintain an efficient mix of wholesale and retail deposits to manage both sides of the risk.

Corporate Governance and the Moral Hazard Problem

Slack corporate governance also played its role in contributing to triggering the crisis. Bank managers and investment banking executives were more concerned with the short-term goals of high volume originations of mortgage assets pursuant to the policy of ‘originate and distribute’ through various SPVs. Similarly, investment banks were also more concerned with the shortterm goals of devising complex structured financial derivatives and MBS, which would bring them structuring and advising fees. All this short-term focus meant that the originating and structuring entities were less concerned with long-term quality. By focusing on short-term originate and distribute strategies managers were able to inflate their short-term performance in the hope of enjoying fat bonuses. Larry Tabb, founder and chief executive of the TABB Group, a capital markets research and advisory firm, sums this up in the following words: ‘In the record year of 2006, Wall Street executives took home bonuses totalling $23.9 billion, according to the New York State Comptroller’s Office. Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm’ (Business Week, October 2008).

Islamic banks and financial institutions need to be wary of such factors and need to build appropriate corporate governance measures to restrict behaviour directed at earning short-term profits at the cost of long-term losses for the investors, customers and the financial system at large. Bonuses and appraisals should be linked to the long-term performance of the underlying structure and products, especially in cases where such products are financial in nature and can pose systemic risk for the financial system at large. In this regard the bonuses could be announced on deferred terms, i.e. the amount of the bonus is announced based on short- term performance, but is payable on a deferred basis based on the long-term performance of the employee and the structured product. Appropriate accountability measures are, therefore, necessary in Islamic financial institutions to safeguard against such practices.

NEWHORIZON    April to June 2013ANALYSIS

Prudent Credit Appraisal and Credit Management Regimes

Credit risk refers to the possibility of default and delay in the repayment of debts. This type of risk is faced by all financial institutions since all enter into transactions involving debts. This type of risk can seriously affect the performance of the financial institution resulting in high, non-performing loans, liquidity crises and other costs. The seriousness of these issues could have major consequences for the concerned financial institutions, e.g. insolvency and bankruptcy, thereby causing a blow to the public’s confidence in the bank. A core factor in the subprime crisis was that there were almost no or very little credit risk measurement and management techniques in place to manage the credit risk; as mentioned earlier credit was based on automated credit approvals and easy terms like NINA and was given to individuals with bad or no credit history.

The mitigation of credit risk requires prudent credit management techniques and appropriate systems to be in place to measure the risk involved in various transactions. For Islamic banks appropriate measures should also be in place to measure the risk involved with the various types of different modes that are employed. Secondly, proper due diligence in credit evaluation of the clients should be done before extending the facility. This again requires proper evaluation systems to be in place, which involves evaluating past credit history and the ability to pay the debt on time, which in turn involves an evaluation of the client’s income.

For Islamic banks it is also essential that in the case of profit sharing modes proper analysis of the viability of the client’s business or the project is done. An important technique to mitigate the credit risk is to acquire collateral against the financings. This requires that a proper valuation of the collateral is done. Furthermore it is also essential to conduct follow-up evaluations of the collateral as well as of the client’s creditworthiness to ensure that the collateral and the client’s ability to pay do not diminish thereby risking default. For Islamic banks it is also essential that the collateral is Shari’ah compliant.

Conventional banks also mitigate against delays in payment by charging a heavy penalty in the form of interest if the repayment is delayed beyond the due date. Islamic banks under certain jurisdictions are not allowed to make such charges for their own gain, but they mitigate the risk by charging a penalty and then giving the sum away as a charitable donation.

Another important way of mitigating credit risk is to diversify the asset base of the bank and since the majority of the assets of banks consist of loans or Shari’ahcompliant financial transactions it is important to diversify the credit base, i.e. credit exposure should not be excessively biased to one sector. Similarly exposure should not be excessively biased to a small number of clients. This is mostly taken care of by the sector limit and per party limit guidelines issued by the regulatory authority and linked to the size of the concerned bank. It is necessary to follow these guidelines to hedge against credit risk and improve the quality of the assets on the balance sheet. Islamic banks in this regard must also ensure that they do not take excessive exposure on one or two Shari’ah-compliant modes, but effectively diversify risk among various modes as far as the situation permits, since each mode has its own inherent risks, which can be mitigated by effective diversification. It is also necessary that 10 20% down payments are made mandatory in mortgage financings to ensure the inclusion of customer equity and the availability of a cushion in the underlying security in times of decreasing housing prices.

Regulation of the Non- Banking Financial Sector and Systemic Risk

The non-banking financial sector has grown around the globe in the past few years. Major players in this sector are the investment banks. To date these institutions have typically been subject to much lighter regulations be it related to equity ratios; leverage restrictions or per party limits. The crisis has, however, taught us one important lesson which can be summed up in the words of Paul Krugman, Professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University. In an article in the New York Times in 2010 he said, ‘As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians, government officials and influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank.’

The implication is that any player in the Islamic financial industry, which acts like a bank, providing finance and taking deposits either through a partnership structure, mudarabah or through debt financing, which results in systemic risk, should be regulated through the same tight regulatory mechanisms that apply to normal Islamic commercial banks. They should be subject to same regulatory and reserverequirements and the necessary capital adequacy ratios.

Restricting Leverage and Increasing Regulatory Capital during Boom Periods

The ownership structure refers to the strength of the sponsors as well as the level of equity involved in the capital composition. The targets of the capital adequacy ratios (CAR) as suggested by the Basel II committee for all conventional banks and the IFSB (Islamic Financial Services Board) CAR standards for Islamic banks should be strictly observed. The regulatory capital requirements should be increased when an organisation goes through a period of high growth especially if that growth is being achieved through high levels of leverage due to the availability of low-rate finance in the market and high growth in the value of assets. As is evident from the crisis increased leverage is not normally a cause for concern since the good results on the asset side; availability of excess and cheap liquidity in the market and high bottom line results, usually hide the inherent leverage risks in the strategy.

Increased levels of equity not only increase the stake of the shareholders in the organisation, which would automatically result in increased oversight by the board of directors, but also augur well for the reputation of any financial institution. Strong sponsors with worldwide holdings and recognition result in a good image among the public. Similarly a government’s stake in an institution up to a certain level may also result in a healthy reputation, although an excessive government stake might result in a negative image.

Securitisation and Derivative Instruments

The Islamic finance industry is maturing with each passing year and the market has seen new complex structures being evolved in the form of Shari’ah-compliant mortgage backed securities. The regulators of the Islamic finance industry need to be attentive to such developments and learn the lessons from the subprime crisis and restrict such tendencies.

Although the securitisation of housing assets results in a growth of liquidity in the market and assists customers requiring lowcost housing, the situation can get out of hand if the securitisation process runs out of control and speculative investors jump in with the aim of profiting from the availability of low-cost financing to gain financial leverage. Such speculative behaviour creates an artificial demand for housing, which results in increased house prices and this is ultimately detrimental to the primary goal of providing low-cost housing finance to real customers. Regulators, while allowing for such securitisation, must also build appropriate regulatory restrictions to deter the speculative practices of investors.

Secondly they must also restrict ‘originate and distribute’ strategies among Islamic financial institutions and banks, which would lead to an unwarranted focus on short-term gains at the expense of long-term asset quality. This can be done by putting a limit on the amount of distribution that an entity can indulge in as a percentage of origination. Similarly speculative investors can be deterred by requiring a high down payment/ deposit for mortgage applicants who already own a residential property.

CDS-type derivatives are inherently contrary to the principles of Shari’ah and it is highly unlikely that any Islamic bank or financial institution would be allowed to invest in such products by their Shari’ah advisors. Recent developments, however, have shown that products such as Shari’ah-compliant cross currency swaps and other products such as call and put option products based on aurbon (commitment fee) and wa’d (undertaking) are being designed. Although such products have been rejected by the majority of Shari’ah scholars; such developments must be seen as alarming signs by the regulators, since, if they are accepted by the majority at any stage, they have the potential to disrupt the industry due to increased systemic risk.

Conclusion

It is still early days for the Islamic finance industry, but due to its compliance with Shari’ah it has been able to withstand the global financial meltdown triggered by the subprime crisis. Its Shari’ahcompliance requirements have deterred it from investing in products, which are based on gambling (maysir) and trading of debts (bai al-dayn). The Islamic finance industry and its players have not, therefore, been exposed to instruments such as CDS and debt-based MBS.

Most Islamic banks have been graced with excess liquidity; generated through retail deposits, which they have been unable to place efficiently due to the limited availability of Shari’ah-compliant liquidity instruments. Apart from these positive attributes the Islamic finance industry and its players need to learn the lessons of the global crisis and to focus on all the key factors discussed in this article, as well as other issues to plug the weaknesses in the system.

At the same time industry regulators need to play an important role by studying the speculative nature of human behaviour and the tendency to indulge in practices designed to make huge short-term gains without acknowledging the longterm risks and the potentially detrimental effects of financial structuring and opportunistic behaviour. Most importantly they need to learn the lesson that free markets with very little or non-existing regulation would not necessarily result in the efficient distribution of financial resources into productive channels. The human psyche or the invisible hand will always tend to result in opportunistic behaviour, which can have detrimental effects. Appropriate and efficient regulation, therefore, is required to control market behaviour.

Suleman Muhammad Ali

Mr Suleman Muhammad Ali is the Manager - Product Structuring & Research at Pakistan’s Meezan Bank Limited leading the product structuring and Shari’ah compliance function related to Islamic structured finance, sukuk issues, treasury and corporate finance. He holds an MBA (Finance) degree from Institute of Business Administration, Karachi and is a Chartered Islamic Finance Professional (CIFP) from INCEIF, Kuala Lumpur. He was involved in the structuring of Pakistan’s first ever short-term KAPCO sukuk and the development of a proposal to launch an Islamic Interbank Benchmark Rate (IIBOR) in Pakistan.

NEWHORIZON    Jamatul Thani - Sha’ban 1434TAKAFUL

The International Takaful Summit 2013 in Cairo, Egypt

In February 2013 the International Takaful Summit (ITS), organised by Afkar Consulting and Istishar IQ, moved from its established London venue to Cairo under the auspices of Egypt’s Ministry of Finance. The rationale for the move was based on the premise that the Egyptian market has great potential for takaful growth and also because Egypt is geographically convenient for delegates coming from the Middle East and Africa. There still remain fantastic opportunities, however, for increasing market penetration in the core markets of Malaysia and the Middle East as well as harvesting the undoubted potential in South East Asia, Africa and some non-Muslim countries with significant Muslim populations. ITS ‘New Frontiers’ investigated the obstacles faced by the industry and sought to provide constructive solutions to nurture the continued development of the global industry. Following is a brief report on the important presentations made at the Summit.

The Takaful Landscape

Sameeulhaq Thanvi, Managing Director, Nile Family Takaful set the scene for world takaful. He pointed out that about 25% of the world’s population is Muslim, the vast majority in the Asia Pacific region, but nearly 20% are in the MENA (Middle East and North Africa) region, around 320 million people in 20 different countries and territories. Egypt has the largest Muslim population in the region (80 million), followed closely by Iran (74.8 million) and Turkey (74.7 million) with Algeria and Morocco quite a long way behind at 34.8 million and 32.4 million respectively.

On a worldwide basis 8% of the population has insurance compared to about 3% in the MENA region with Bahrain and Morocco having roughly the average 3% with insurance, the UAE and Tunisia 2%, Iran 1.5%, Oman 1%, Egypt 0.7% and all the rest less than 1%. Interestingly, according to figures from E&Y, after solid growth in takaful contributions between 2005 and 2009, 2010 saw a decline except in Qatar where takaful contributions grew 91% in 2010.

Ashraf Al-Azzouni, Managing Director of RGA Reinsurance Company Middle East Ltd provided further background on the takaful market. He said that in the 1980s there were less than 12 takaful operators. That has grown to 195 today, 77 of which are in the GCC. The market according to Ernst & Young is worth $12.8 billion with Saudi Arabia accounting for 44% of the market, South East Asia 27% and the GCC 19%. He commented that takaful growth is linked to levels of disposable income.

Speaking about the potential for takaful growth in Africa, Omar Gouda, Managing Director of Africa ReTakaful identified Algeria, Egypt, Morocco and Nigeria as among the most promising markets. He also identified the factors that will help to promote growth and these included an appropriate legal framework, investment in infrastructure/support institutions, the establishment of a pan-Africa body to co-ordinate takaful companies, developing the relationship between market players and governments, education and training for industry participants and a raising of the awareness of takaful among populations. He said, ‘The products that we are supplying, the distribution channels we are employing and the rules and regulations we adhere to, must all be understood clearly by everyone.’

Dr Walid Hergazy of Hergazy and Associates outlined the situation in Egypt, where there are 30 insurance companies operating, 13 of them foreign owned, generating EGP (Egyptian Pounds) 8.8 billion in premiums and with total investments of EGP 58 billion. These companies are governed by a single law, which does make provision for cooperative insurance. There is a single regulator which is the Special Insurance Committee of the EFSA (Egyptian Financial Services Authority).

Islamic finance and takaful insurance products are growing worldwide in a way that is encouraging their adoption by Islamic as well as non-Islamic countries to support economic growth. Egypt introduced the first Islamic bank in 1963 and in 2003 launched the first takaful insurance company. The increased demand and success of these products triggered the desire of the Ministry of Finance to support the International Takaful Summit and its objectives. We believe that the summit will help increase the awareness of Islamic banking and takaful insurance principles and practices which will in turn help in the expansion of the Islamic finance and the takaful industry in Egypt.
Comment from Egypt’s Ministry of Finance

The conference identified retakaful as one of the current obstacles to growth in the takaful industry. It is common practice in conventional insurance for operators to pass on an element of their exposure to third parties – reinsurance companies and, indeed, some takaful operators have found themselves forced to use conventional reinsurance due to the shortage of suitable retakaful alternatives. As the Islamic finance industry matures and begins to codify its approach to risk sharing, the retakaful sector will grow, and indeed signs of that growth can be seen in the Middle East today, but in the short term it is likely to continue to be something of an issue.

The Co-operative Model

Interestingly Saudi Arabia is the biggest market, although strictly speaking it is not a takaful market. Saudi Arabia requires operators to work under a system called the co-operative model, which is very similar to takaful. Most re-takaful operators are permitted to do business with them. A number of takaful operators have subsidiaries in Saudi Arabia working in compliance with the co-operative model.

Saleh Omair, General Manager of Amana Co-operative Insurance said that the co-operative model had been chosen by Saudi Arabia’s government due to its voluntary nature and the social, economic and cultural benefits that it brought. He said that co-operative insurance and takaful were very similar in that the underlying principles of both were accepted under Islamic law. The main difference is that the co-operative model entitles participants to share in any net surplus from a co-operative company rather than only receiving the surplus from the claims pool. In 2011 all Saudi insurance companies were required to convert their existing products to adhere to the co-operative model.

Gross premiums grew nearly 13% in Saudi Arabia between 2010 and 2011, reaching a total of $4.9 billion. Health insurance was the largest sector accounting for nearly 53% of premiums with general insurance accounting for nearly 43%. The smallest sector is protection and savings insurance at just under 7% of total premiums.

Microtakaful

The first day of the conference saw a significant concentration on the topic of microtakaful. Susan Dingwall, a partner at the law firm, Norton Rose set the scene talking about the challenges that face this sector of the market. Although some governments have intervened to kick start microtakaful, part of the problem is a lack of awareness among potential customers of the benefits of protection and on the other hand a lack of suitable products to meet the market needs. She highlighted some of the products that have been developed to meet market needs – livestock policies in Africa, affordable funeral insurance in Trinidad and Tobago, medical insurance in Sri Lanka and personal accident cover for Indonesian maids. She also commented that conventional regulatory regimes may in fact hinder market development and suggested that a tiered regulatory regime may prove to be the answer.

Omer Elfarowg Ahmed, Assistant Managing Director Underwriting, Shiekan Insurance Company, highlighted the way in which the Sudanese government’s initiative on microfinance has been good for microtakaful and vice versa.

In Sudan the Central Bank of Sudan (CBOS) directed commercial banks to direct 12% of their lending portfolios to microfinance (about $650 million). In 2008 in response to this directive Sudanese insurance companies began to offer microtakaful products. It was hoped that among other things this would help to encourage banks to make loans to small enterprises, thereby alleviating poverty and protect microfinance funds against default risk. Under the system the government pays 50% of agricultural insurance premiums.

There are, however, challenges such as raising the awareness of microtakaful; developing efficient risk management tools, the lack of credit information and reinsurance capacity.

Rating Takaful Companies

Vasilis Katsipis, General Manager, Market Development MENA, Central and South Asia for AM Best, the ratings agency, examined the ways in which takaful regulation impacted ratings. He said that the capitalisation of takaful companies cannot be evaluated in the same way as conventional insurance companies. He particularly highlighted permanence, which is the ability to pay insurance company obligations at all times. In takaful most policy holder funds depend on qard hassan (an interest-free loan) for their viability and that loan should be repaid if it becomes clear that the policyholder fund is unable to return to profitability, making it difficult to meet the obligations at all times.

Second, he highlighted the ability to defer interest or dividend payments. In takaful dividends can be and usually are paid from the operators fund, while the policyholder fund is loss making. Third is subordination in an insurance company’s structure, through which policyholder liabilities have priority in cases of insolvency. Scholars have taken the view that there is no subordination in Shari’ah law.

He suggested that the legal/ regulatory framework can bring some clarity on these issues, but in the MENA region this regulatory clarity only really exists in Bahrain, the Dubai International Financial Centre and the Qatar Financial Centre. In other places the permanence of qard hassan is uncertain; policyholders do not have seniority over other liabilities and it is unclear which legal system will apply in cases of insolvency. Mr Katsipis suggested that there were actions that takaful companies operating in weak regulatory regimes could take to improve policyholder protection. For example, they could incorporate the missing regulatory rules in their policy wording and ring fence funds in the operator’s fund for use as qard hassan, although this would clearly increase costs.

He concluded by saying that regulation is critical to the rating prospects of all insurers including takaful companies. Mr Katsipis pointed out that variability in regulation was particularly harmful in the case of takaful, which as a very young industry needs to be seen as secure and dependable.

Takaful – An Alternative to Conventional Insurance

The conference also discussed the widely held misconception that takaful is only for Muslims. In Malaysia, for example, takaful has had some success among non-Muslim customers, probably attracted by the ethical nature of takaful. To take full advantage of the potential that exists among non-Muslim customers, it was suggested that the takaful industry needs to increase the range of its products, offering alternatives to products promoted by the conventional insurance sector. Sameeulhaq Thanvi, Managing Director of Nile Family Takaful went so far as to suggest that one way of increasing the appeal would be to change the product label, removing words such as ‘Islamic’ or ‘takaful’ and replacing them with ‘ethical’.

The International Takaful Awards

The conference also saw the announcement of the 2013 International Takaful Awards. Best takaful awards went to General Takaful, Qatar; Salama from the UAE; Solidarity, Bahrain; The Islamic Insurance Company, Jordan; Prime Islamic Life Insurance Ltd. Bangladesh; Wethaq, Kuwait; Ta’awuniya Insurance Company, Sudan; Pak-Qatar Family Takaful, Pakistan; Weqaya, Saudi Arabia; Nile Takaful, Egypt and Takaful Malaysia. In the best retakaful category awards went to the African Reinsurance Corporation and Hannover Re for the Middle East. The National Bank of Abu Dhabi won the award for the best asset management company; Norton Rose was the winner of the best legal firm award and Centegy Technologies were voted the best technology company.

NEWHORIZON    April to June 2013ACADEMIC ARTICLE

The Objective of the Shari’ah in Islamic Finance: Identifying the Ends and the Means

Associate Professor Mohammad Akram Laldin and Dr Hafas Furqani, ISRA

This paper is an abridged version of a longer paper produced by ISRA and reproduced with their permission. Readers who wish to access the full text can do so by registering on the ISRA web site, www.isra.my.

Introduction

Islamic banking and finance’s (IBF’s) emergence as a practical financial system is viewed as timely in the midst of a world financial crisis and uncertain solutions to solve the crisis. Although the phenomenon might be seen by some as part of the global Islamic resurgence to reconstruct Islam’s legacy in modern times, the interest in its practice is actually triggered by the philosophy and system of value it offers. It is expected that Islamic banking and finance can offer a coherent perspective for understanding real economic problems as well as a genuine alternative to the very foundations of how economics and finance should be managed for human prosperity.

This spirit is very much reflected in the concept of maqasid al-Shari’ah (objectives of the Shari’ah), which comprise the basic philosophical foundations that give guidelines and justifications for IBF’s raison d’être in contemporary times. In Islam, finance is viewed as part of the Shari’ah. Adherence to maqasid al-Shari’ah as the grand objective of Islam is necessary for developing genuine and indisputable ‘Islamic’ finance. We see recognition of this reflected in increased interest in using the maqasid as a guide for developing Islamic finance. During the first three decades (1970s-1990s) of attempts to Islamise modern financial products, scholars and practitioners who structured Islamic financial contracts mostly focused on technical considerations for fulfilling Islamic legal requirements. There is, however, growing acknowledgement that meeting legal requirements through comprehensive and systematic technical procedures is not sufficient. Attention should also be paid to the objectives of the Shari’ah. The ‘Shari’ah compliant’ title carries the expectation of a financial system and practices that are truly based on all the tenets of the Shari’ah, namely the Islamic legal principles and ethics that serve the noble goals prescribed by Islam.

In that light, this paper attempts to discuss the issue by exploring the objectives of the Shari’ah, which signify the philosophy and goals that Islam propagates in the effort to establish an Islamic financial system. The maqasid discussion will give us insight on the raison d’être of Islamic finance; provide guidelines for the future direction of the industry and what objectives are to be achieved.

Maqasid al-Shari’ah: Meaning and Scope

Maqasid al-Shari’ah is translated as the objectives of the Shari’ah. In the financial sphere, maqasid al-Shari’ah is considered to be the grand framework that provides guidelines and directions for ensuring the realisation of maslahah (benefit) and the prevention of mafsadah (harm) in all financial contracts. These objectives, however, remain theoretical until they are applied and brought into the realm of reality. Before we discuss the concept of maqasid al-Shari’ah, it is important to understand the meaning and scope of the Shari’ah. This is because the Shari’ah is the crux of the discussion and the maqasid are only the goals derived from it.

One view identifies Shari’ah with Islamic laws regulating the Man- God relationship and interactions between people. Shari’ah in this perspective is limited to the domain of law that regulates practical aspects of human life: personal, societal, state or international relationships. When Shari’ah is reduced to Islamic law, it is then often equated with fiqh. In this dimension, maqasid al-Shari’ah are put in the framework of the objectives of ‘Islamic law’ or the objectives of Islam in legislation.

A second view of Shari’ah is wider, considering it a system of life that encompasses all aspects of the belief system, the system of ethics and morals and the rules governing the Man-God relationship and human relationships. Shari’ah in this perspective covers the entire spectrum of Islamic life, including belief, morality, virtues and principles of guidance on economic, political, cultural and civilizational matters that concern not only the Muslim community but all of humanity. By this consideration, Shari’ah could be understood as synonymous with religion, encompassing all of human life.

This understanding comes from the original linguistic meaning of Shari’ah as a ‘source of water’ or ‘path to a watering place’. Shari’ah is therefore an all-embracing concept and framework that exists to support human existence and provide the necessary principles, values and means to establish human wellbeing in this worldly life and the hereafter.

This paper embarks from the second definition of Shari’ah. What is meant by maqasid al-Shari’ah is all the goals and objectives of Islam as a system of life that constitutes standards and criteria, values and guidance based on divine revelation to be applied in practical life to solve human problems and guide the direction of human life. More narrowly framed, maqasid al-Shari’ah are the underlying purposes upon which the Shari’ah is established.

The discussion of maqasid al-Shari’ah in Islamic finance should be seen in the broader perspective. It should not be confined to Islamic objectives in laws related to financial activities. In fact, it encompasses the purpose of Islam in financial activities. While we agree that observing the philosophical underpinning of legal rulings is important, a maqasidic discussion would extend the subject matter to why and for what purposes the contracts and financial activities are permitted or prohibited. The discussion of Shari’ah in Islamic finance does not halt at what contracts are permitted or prohibited, what elements should be observed or what mechanisms should be followed to make the contracts legally valid, as per the dominant current discourse in Shari’ahcompliant finance. Instead, the maqasid discussion will open up the horizon of raison d’être: why we need to develop Islamic finance in the first place, what goals are to be realised and in what direction the industry should proceed.

Maqasid al-Shari’ah: Sources and Dimensions

The ultimate source of maqasid al- Shari’ah is the Qur’an and Sunnah. The two are the prime textual sources of Islam. The maqasid are often found in texts that explicitly or implicitly declare the purpose of the Shari’ah in human life. In this endeavour, intellectual reasoning is significant. The interaction of texts and reasoning is not only legitimate but encouraged; the combination is necessary for elaborating those comprehensive objectives, which are relevant to every aspect of life and those that relate to particular domains. They are derived through direct interaction with the texts, which necessarily involves a certain measure of independent reasoning and intellectual exertion as those texts (particularly in interactions between people) tend to be expressed in general terms, leaving the technical procedures and details of application to the wisdom of human beings. The Qur’anic statements on economics, in particular, lay down ethical guidelines and principles as the foundations for an Islamic value system in economics, instead of supplying operational mechanisms for how the system would work. Intellectual rigour, therefore, is required to elaborate detailed rules and ensure that the Shari’ah is applied in an appropriate way so that the objectives it promotes are realised.

The rigorous technical rules of usul al-fiqh for interpreting texts and deducing laws have undergone centuries of discussion, debate and refinement. When the science of maqasid is used in tandem with this time-tested methodology, it opens up the avenues of thought in the effort to realise the spirit of the Shari’ah in practical legal rulings. This approach would not only observe the ‘correct mechanisms’ in the technical/procedural sense but, most importantly, be able to capture the essential spirit and noble goals with regard to particular actions. Hence, errors arising from a rigid literal reading of the text could be avoided. It will open up the horizons by understanding texts in relation to the context of practical realities and view the Shari’ah as a unity in which the detailed rules are to be read within a general framework and detailed actions are to be set in line with larger goals. Maqasidbased intellectual effort would link the Shari’ah principles and objectives to all situations in a two-way process that ensures ‘correspondence’ between human circumstances in all places and times and the grand framework of the Shari’ah.

Shari’ah Objectives in Financial Activities: Identifying the Goals (Maqasid)

As the Shari’ah is designed on the basis of and for the purpose of human benefit, maqasid al-Shari’ah constitute the various dimensions of human needs; their fulfilment will create balanced satisfaction in human life at the level of both the individual and the society and help realise human wellbeing. Maqasid would, therefore, encompass the micro and macro dimensions of individual and collective life. With reference to Islamic finance in particular, maqasid al-Shari’ah refer to the overall goals and meaning that the Shari’ah aims to achieve from its principles and rulings related to financial activities and transactions.

The maqasid discussion in the literature on Islamic finance is usually framed in terms of the protection of wealth. This approach is justified as the subject matter of finance is basically how to allocate resources from the surplus sector (capital providers) to the deficit sector (capital users) so that wealth is smoothly circulated and human welfare is realised. As finance deals with wealth allocation and appropriation (from mobilisation until utilisation), the maqasid that come under the rubric of the protection of wealth should, therefore, be understood and discussed by looking at the nature, function and role of wealth in relation to the primary objective of realising human wellbeing, individually and collectively, by acquiring benefit and preventing harm (Qur’an, 5:6).

Reflecting upon various texts of the Qur’an and the Sunnah on financial activities, it can be stated that the Shari’ah has observed specific objectives in the enactment of financial laws and principles. These objectives serve the financial needs of human beings. They include the circulation of wealth in the society, enjoining fair and transparent financial practices and promoting socio-economic justice.

Wealth Circulation

Wealth circulation comprises all processes related to its creation, consumption and distribution. This objective is derived from the Qur’an, which provides, as a rationale for instructions to distribute one source of wealth among a number of different groups, ‘…so that wealth is not circulated among the rich in the society only’ (Qur’an, 59: 7).

Islam intends to ensure that resources are circulated in the economy to activate human potential in the pursuit of wellbeing and intergenerational continuity. This perspective embarks from the concept that wealth is considered as God’s bounty entrusted to its recipient. As God’s bounty, wealth itself reflects the blessings of God on man (Qur’an, 62: 10) and it is, therefore, naturally good. Working to acquire wealth is, therefore, not only legitimated but highly praised (Qur’an, 16:97; 4:32).

While private ownership and consumption are recognised, they have not been created merely to satisfy man’s wants and, hence, deny and neglect those of society. Instead, wealth is to be used in the best way to fulfil the needs of individuals and society for a better life without any corruption or misuse, wastage and squandering. Likewise, short-sighted, selfinterested behaviour in acquiring and utilising wealth by spoiling the environment, or at the expense of society and future generations, is strongly condemned. Wealth should be created and augmented through the right means and spent for the right ends.

Commercial and financial activities are viewed positively as mechanisms to circulate wealth among all the sections of society so that it is not concentrated in the hands of a few and instead goes into all sectors of the economy that would benefit human wellbeing. Islam encourages wealth to be employed in productive activities. The funds should not be wasted, left idle or used unprofessionally. In fact, any funds that are not employed will be ‘penalised’ through zakat, which will gradually reduce the volume of wealth and put it back into circulation.

The Islamic economic system as a general framework would ensure fair and equitable mobilisation and distribution of resources. Islamic finance, in particular, is developed in line with Islam’s objective of wealth circulation by observing Islamic rules on transactions, which have been legislated to protect wealth. Islamic financial institutions, including Islamic banks, takaful companies and mutual funds, play a role in circulating resources in society and increasing human wellbeing.

Fair and Transparent Financial Practices

Permissibility is the overarching principle governing commercial and financial transactions. This principle is aimed at facilitating the realisation of benefit and the removal of hardship in financial transactions. Freedom of contract is therefore not only recognised as part of the system but is also guaranteed and treated as a necessary element of a valid contract. Nevertheless, this freedom is to be used within an atmosphere of fairness, equity, justice and high morality. Any contract stipulated and agreed by both parties should be respected and enforced.

Transparency means that all financial transactions must be conducted in such a manner that all the parties are clear about all important facts concerning the transactions. This information symmetry prevents the main cause of disputes and damage to any party in all dimensions of the contract. The Qur’an has stressed that all agreements and contracts should be as transparent and clear as possible.

Fairness means equity between the transacting parties, honesty and truthfulness, as well as efficiency in transactions. Fraud, deception and manipulation of any kind are therefore condemned. Islam insists that the contract is only legitimate if there is mutual consent of the parties. A transaction that takes place under pressure or accompanied by fraud or misrepresentation by any party is not valid. Likewise, Islam disapproves all commercial practices that involve explicit or implicit harm and injustice to one of the contracting parties or to the public at large or which restricts freedom of trade, or stands in violation of the Qur’anic injunctions and approved business conduct.

The purpose is to protect the contracting parties from mutual injustice and resulting disputes. In addition, this objective also seeks to rid Islamic finance from misuse and squandering and to prevent disputes, arguments and grudges among the community regarding financial matters as well as to prevent one party’s gain at another’s expense. Justice and fairness are the hallmark values in commercial contracts. If it proves to be an instrument of injustice, such a contract must be set aside, and justice, which is the goal and maqasid of the Lawgiver, must be given priority over considerations of conformity to an untenable contract.

Justice in the Macro and Micro Dimensions

The maqasid of wealth circulation is a macro goal of the Shari’ah, while the maqasid of fair and transparent financial practices are related to micro goals of the Shari’ah in transactional instruments and mechanisms. The maqasid of justice embraces both micro and macro dimensions. This maqasid is related to the desire to have a just order of society as well as just dealings among individuals in financial transactions. Justice in Islam embraces the individual and social dimensions.

This objective is characterised in the Qur’an with the concepts of right, fairness, putting things in their right place, equality, harmony, balance and moderation. It is a right to have equal opportunity, to be free from exploitation and to receive true value in exchange for one’s labour. This objective underlies the substantive and regulative rules of the Shari’ah, the formation of the community and the behaviour of individuals.

At the macro level, the goal is to realise social justice. The Islamic financial system attempts to realise economic justice through wealth circulation, efficiency in resource utilisation, fulfilling society’s basic needs, elimination of poverty and improving human wellbeing. The main purpose of resource circulation (distribution) is to achieve justice, maximum efficiency and the improvement of human wellbeing in general.

This is really a challenge as earthly human life has a natural tendency to end up with unequal distribution, i.e., inequality is natural; humanity is made up of the rich and the poor, the bright and the dull, the strong and the sick, the haves and the have-nots. The very structure of society is built up on the basis of human inequality as a ‘test’, a moral struggle by individuals on the basis of mutual dependency despite the differences in Divine gifts, but human beings are expected to cooperate among themselves to achieve the desired objectives. Inequality requires the rich to help the poor and the needy rather than taking the opportunity to exploit others. While competition among society is appreciated, cooperation that results from the spirit of brotherhood among society is more appreciated. Such social commitment is praised in the Qur’an as a mark of the individual’s spiritual ascent.

The Islamic system of economics is structured to coordinate and harmonise the various economic interests of individuals and groups within the society to achieve the ideals mentioned above. Islam sustains this social dimension by establishing important economic institutions such as those to standardise distribution of inheritance and support charitable endowment, charity and spending for good purposes. This is done on the basis of obligations as well as voluntary actions that emerge from an individual’s consciousness of human brotherhood to contribute to society’s development. This mix of individual freedom and social justice describe the egalitarian principles of Islam that ensure the system is both efficient and equitable. This framework guarantees a free market with a fair process and just mechanism that ensures fair circulation of resources in society and maintains a stable yet dynamic economic life.

The State also plays a role in an Islamic economic system to ensure that individual freedom is respected while social objectives are achieved. Justice also embraces individual dealings. Economic transactions demand equal rights and opportunities and cannot become effective without the mutual consent of the contracting parties. Likewise, unfair dealings or unjustified actions that lead to economic injustice or exploitation, such as bribery, fraud or deception, cheating, uncertainty and lack of clarity or unjustified increase in wealth or riba are condemned. Riba is highly correlated with injustice. The prohibition is not limited to interest on loans. Instead, it is a comprehensive concept that encompasses all factors of production and distribution, such as capital, land and labour whereby one party attempts to gain benefit at the expense of the other party without giving a reasonable counter value. Riba is forbidden on the grounds that it fosters the unjust acquisition of wealth at the expense of social justice, the equitable distribution of wealth and the wellbeing of the community. The abolition of riba also implies that Islam promotes cooperative and participatory financing for the mobilisation and circulation of resources in society as a means of realising general productivity and wellbeing.

Maqasid al-Shari’ah in Islamic Financial Activities: Instituting the Means

As the objective of the Shari’ah is none other than human wellbeing, the Shari’ah provides the necessary ways and means to establish and preserve it in the actual human context. Maqasid in the means of achieving maqasid, however, differ in certain aspects of their nature. While principles and objectives are permanent and unchanging, the means are relatively temporary, dynamic, conditional and amenable to change. The means are not restricted or limited, and hence creativity and elaboration are required so that the maqasid can be effectively achieved. The following discussion will investigate some of these directives and mechanisms.

Facilitating Financial Contracts

To institute smooth circulation of wealth in society, the Shari’ah facilitates various types of transactions and strongly encourages Muslims to participate in and undertake necessary types of financial activities. In commercial activities, the underlying principle is that of permissibility. The transactions validated in the Qur’an and Sunnah are not exhaustive and new transactions can be introduced as long as they do not contradict the principles of the Shari’ah. Freedom of contracts is, therefore, guaranteed as long as it does not annul fairness and good measure as propagated by the maqasid al-Shari’ah.

In general, Islamic nominate contracts related to economic transactions are classified into three main categories: exchange, partnership and gratuitous. Exchange contracts include simple spot sales (bay’), sales creating debt such as ijara and istisna and work done for a reward (jualah). Partnership contracts are ones in which one party assigns work/ capital/obligation to one or more other parties. These contracts include agency (wakalah), partnership (sharikah) contracts in the forms of murabaha and musharakah, debt assignment (hawalah), and pledge or mortgage (rahn). In gratuitous contracts, ownership or rights of use are transferred without consideration (payment) or compensation. Gratuitous contracts include loans, deposits, gifts and guarantees. Every contract is designed to serve a particular purpose. The contract should, therefore, be respected and fulfilled, not only in order to protect the interests of the parties involved in it, but also to serve the very purpose of the contract that caused the parties to enter into it and willingly bind themselves to it.

If a contract were irregular due to some of its conditions, it would have to be fixed. If it is defective in its pillars, it would be considered void and is irreparable. Dissolution of a contract after it has become valid and enforceable, but before or during its execution, is possible through either mutual agreement or revocation and termination due to special reasons such as impossibility of contractual performance or automatic dissolution by death, destruction of the subject matter, expiry of the period or achievement of purpose. This is because the Shari’ah firmly stands for cooperation and fair treatment among the contractual parties. It does not, therefore, allow a loophole to exist so that unfair or unjust treatment could happen.

This spirit marks the Islamic approach in commercial (financial) dealings as not only formal but also substantial. While certain formalities and substantive elements are essential for a transaction to become legally binding on the parties, this should be done through mutual agreement that brings about mutual consent and satisfaction. Therefore, along with approval of various contractual facilities and the emphasis on fulfilment of contractual obligations, Islamic law also provides various ways to remove contractual obligation in situations of unavoidable difficulties and necessities.

Establishing Values and Standards

Transparent and fair dealings are considered among the main objectives of the Shari’ah in financial transactions and activities. The Shari’ah, in this regard, aims at creating an equal and fair transactional atmosphere and at protecting the parties against exploitation or imbalance between their reciprocal rights and obligations. Such imbalances tend to result from a lack of fair and objective criteria by which their rights and obligations can be determined with an acceptable degree of exactitude and certainty. The application of the Shari’ah in the financial sphere should therefore not result in injury, harm or difficulties to either individuals or the public at large as the Shari’ah intends to create a positive atmosphere in commercial transactions whereby exchanges are done on the basis of brotherhood, cooperation and mutual benefit to both parties. The Shari’ah, therefore, institutes some values, measures and standards to be upheld in the transactions and indicates certain negative elements to be avoided, as they would nullify the objective. Those values and standards would relate to both the macro-maqasid dimension of having wealth circulate smoothly in society and the micro-maqasid aspect of having fair and transparent financial dealings. Economic exchange in Islam is inseparable from Islamic values, which must be translated into practical rulings that prevent corrupt acts such as unfair dealing, abusiveness, stinginess, greed, unbridled individualism and exploitation of others. At the same time, truth and honesty, responsibility, trust, generosity, justice, friendship and cooperation are highly encouraged and must be preserved in financial dealings. These values would not only protect customers, stakeholders and the public, they would also promote smooth allocation of resources and fair dealings in transaction.

According to Abtani (2007), ‘Islamic law cannot be separated from its moral, ethical and religious principles; otherwise, its rules will be useless. In other words, the Islamic system cannot be secular. This is because all Islamic rules, including economic and political, are connected with the faith, beliefs and worship of Islam.’

Beyond the realm of values, the Islamic economic system has instituted various ways to spend for the sake of Allah such as zakat and qard. These would cultivate the spirit of brotherhood and mutual cooperation in society, assist the circulation of wealth, activate the economy and increase productivity. Conversely, destructive tendencies have been prohibited, for example unnecessary spending, selfindulgence, spending on unlawful activities and stinginess. oarding is also prohibited as it prevents wealth from circulating by halting supplies. Likewise, illegal means of wealth acquisition or causing harm to others in wealth creation are also prohibited.

From the micro-perspective of transactions, in the effort to achieve justice, Islam puts in place measures to ‘level the playing field’ among the parties to a contract. That includes the removal of factors that would distort equality or allow one party to gain at the expense of the others. Among the main negative elements are riba and gharar. Riba is banned because it allows unjustified increase in wealth in transactions, whether in loans or sales. An essential feature of riba is that it transfers risk onto one party and shields the other from it and guarantees it a fixed return. In a loan, riba transfers risk to the debtor, by requiring him to pay back the money lent with increment. Certain sales, especially those involving delayed payment, can be structured to transfer all risk to the buyer without the seller assuming risk, liability or effort. Riba could also arise due to unequal exchange in a sale.

Gharar is also prohibited and considered a major negative element that would prevent a fair financial transaction. Gharar is defined as a characteristic that renders the consequences and future outcome of a transaction unknown or uncertain. It is a transaction done on the basis of pure speculation in a state of ignorance due to uncertainty about the existence of the contract’s subject matter or failure to properly identify it, e.g., its genus, type or quantity, or uncertainty about the ability to deliver it, time of delivery or time of payment. Transactions containing gharar usually lead to dissatisfaction on the part of the parties involved and cause harm and/or conflicts between them due to the attendant ambiguity.

In the maqasidic approach, law and ethics, values and practices, form and substance should integrate and not contradict one another. Shari’ah prohibitions and parameters should not, therefore, be understood in a merely legalistic or formalistic manner. Instead, attention should be focused on the core and substance of values and principles. In banking and finance activities, for example, the Shari’ah injunctions should be integrated in the operational activities with genuine concern for fair and transparent practices that contribute to the development of society and human wellbeing.

Instituting Social Responsibility

In the spirit of social justice, Islam balances individuals’ rights and their duties and responsibilities towards others. The concept of social obligation puts a responsibility on those who are capable or better off to assist those who are not capable or worse off. As it is an obligation, social responsibility is therefore not an option. This framework of mutual cooperation and assistance should become the social context of an Islamic economy, whereby society will grow without disparity, indifference or exploitation.

As wealth is a trust or amanah the Qur’an indicates that a person may consume according to his need. The remaining income or wealth should be spent in charity or the cause of Allah or reinvested in a business where it may produce more wealth and contribute to employment and income for others.

While it is preferred that this responsibility be undertaken from a moral consciousness that it is right to take care of and assist fellow human beings, an Islamic economy is also realistic in acknowledging the responsibility of the state. It is a factual reality that man, left to himself and to market forces, would most likely not reach the desired goals and objectives spelled out above due to weaknesses in individuals. Some other mechanisms are therefore needed. This calls for state involvement by setting up regulations, laws and policies, as well as institutions of civil society to help, along with government, to provide a social safety net for the disadvantaged. The constraints imposed, and incentives offered, by the norms, values and culture adopted in a society are also important.

The emergence of Islamic banking and finance should be viewed in this context. IBF is a part of Islamic economics that has the potential to contribute richly to the achievement of the major socio-economic goals of Islam such as socio-economic justice and equitable distribution of income and wealth. The establishment of IBF is not an attempt to merely fulfil Muslim society’s desire to have a ‘legal’ form of financial services in a strict legalistic (formalistic) sense by cleansing economic and financial practices from interest (riba), gambling (maysir), uncertainty (gharar) and other prohibited elements commonly found in conventional financial services.

Corporate social responsibility on the part of IBF is more expected in society since the institutions carry the ‘Islamic’ name, which implies that the institutions would promote Islamic ideals and objectives in human life. Islamic banks and financial institutions should take maqasid into account in setting their corporate objectives and policies and also use them to verify compliance to true Islamic principles; IBF’s progress will be monitored by how well it realises the maqasid in producing a good economy marked by the spirit of brotherhood and cooperation, social equality and social justice, just and fair allocation of resources, elimination of poverty, protection of the environment and achievement of general wellbeing.

Conclusion

Maqasid is a comprehensive concept that explicates the very ideals/objectives of the Shari’ah related to human life. As the Shari’ah is an all-embracing concept that is concerned with human life and human wellbeing, maqasid should not be reduced to objectives in the legal dimension. The maqasid discussion in the financial sphere should always refer to the general objective of the Shari’ah, which provides a grand framework and direction for how financial transactions should be arranged in an Islamic economic system. Our perspective should not be limited to fulfilling the minimum legal requirements and calling that Shari’ah compliant. In the framework of maqasid Islamic finance and banking activities lead to the actualisation of Shari’ah objectives by realising benefit and preventing or repelling harm. In this endeavour, the discussion would embrace the micro and macro dimensions of individuals and of society in general. The maqasid would include smooth circulation of wealth, fair and transparent financial practices and justice and equity at both the micro and macro levels. In order to realise those objectives, the means instituted by the Shari’ah include facilitating financial contracts, establishing values and standards as well as inculcating a sense of social responsibility. The future trend in the development of Islamic banking and finance is expected to adopt maqasid al-Shari’ah as the indispensable framework for structuring Islamic financial contracts and as the directional guideline for further development of the industry. Fulfilling minimum Shari’ah legal compliance in product structuring is viewed as insufficient. Instead, movement towards realising maqasid al- Shari’ah is highly valued as the means to give Islamic banking and finance a meaningful presence. This would have an impact of economic substance in the form of just and fair allocation of resources, real economic sector development and fair and transparent financial dealings with all the ethical hallmarks of brotherhood, cooperation and risk sharing.

Yusuf DeLorenzo

Dr Hafas Furqani is currently a researcher at International Shari’ah Research Academy for Islamic Finance (ISRA). He received a Ph.D in Economics (2012) as well as a Master of Economics (2006) from the Department of Economics, International Islamic University Malaysia. His bachelor degree is in Shari’ah Mu’amalah from the State Islamic University Syarif Hidayatullah Jakarta (2002). Hafas has written and published articles in the areas of Islamic economics, banking and finance in academic journals as well as newspapers and magazines.

Yusuf DeLorenzo

Assoc. Prof. Dr. Mohamad Akram Laldin is currently the Executive Director of ISRA. Prior to joining ISRA he was an Assistant Professor at the Kulliyah of Islamic Revealed Knowledge and Human Sciences, International Islamic University, Malaysia (IIUM). In the period 2002-2004, he was a Visiting Assistant Professor at the University of Sharjah, Sharjah, United Arab Emirates. He is also a member of several Shari’ah advisory boards and a committee member of AAOIFI. Dr. Akram holds a B.A. Honours degree in Islamic Jurisprudence and Legislation from the University of Jordan and a Ph.D. in Principles of Islamic Jurisprudence (Usul al-Fiqh) from the University of Edinburgh in Scotland.

NEWHORIZON    Jamatul Thani - Sha’ban 1434CONFERENCE REPORT

Jeddah Roundtable Declaration Fosters a Greater Consensus on the Future Direction of Islamic Finance

Marjan Muhammad,
Researcher, ISRA

The International Shari’ah Research Academy for Islamic finance (ISRA), in collaboration with the Islamic Research and Training Institute (IRTI) and Durham University, jointly organised a oneand- a-half-day roundtable discussion from 31 March to 1 April, the third annual event in the series, at the Islamic Development Bank Group’s headquarters in Jeddah. The main objective of this strategic roundtable is to provide a platform for constructive interaction and discussion among significant stakeholders from Islamic banking and finance namely Shari’ah scholars, Muslim economists and industry practitioners as well as regulators. In addition, the roundtable aims to foster mutual understanding and respect among these stakeholders, so that the persistent dichotomy of views can be minimised.

This third roundtable represents a continuation of the discussions of previous years. The 2013 strategic roundtable discussed the theoretical and practical aspects of risk sharing under the theme – ‘Risk Sharing in Theory and Practice: Fiqhi Evidence vis-à-vis Current Reality’.

After lengthy deliberations on the theme, the participants acknowledged that the recent global financial and sovereign debt crises were the result of over-dependence on interest-based debtfinancing instruments, which reflect the concept of risk transfer that is central to the conventional financial system paradigm.

The participants also agreed that the Islamic financial system represents a financial structure substantially different from the dominant paradigm. The Islamic finance paradigm points to a full-spectrum of instruments serving a financial sector embedded in an Islamic economy in which all rules of market behaviour prescribed by Shari’ah are fully operational and observed. In addition, Islamic finance emphasises justice in the financial system by mobilising funds via micro financing.

The essential function of this spectrum would be to spread and allocate risk among market participants and not to allow a select group to avoid it by transferring it to other stakeholders. Risk sharing is applicable across all products and instruments in the Islamic financial sector as it is inherent in the various mu’amalah contracts that underpin them. Indeed, the acceptance of risk is the justification of the profits earned by participants. It is also acknowledged that Islam promotes redistributive risk-sharing instruments through which the economically more able segment of the society shares the risks facing the less economically able segment of the population.

Having mentioned the above, the 3rd Annual ISRA-IRTI-Durham Strategic Roundtable Discussion 2013 agreed on the following recommendations presented under three broad areas:

Regulatory

1. In order to promote equity-based financing, the legal, tax and regulatory framework should be adjusted to create a level playing field for equity vis-à-vis debt.

2. Regulators should embrace a public policy based on the Maqasid approach in regulating Islamic financial products by evaluating their impact on individuals and society. This requires the active involvement of various stakeholders including Shari’ah scholars, economists and practitioners.

3. Given the detrimental effect of excessive debt to individuals and the economy, regulators should endeavour to find the optimum balance of equity and debt for the economy.

4. Regulators should monitor and control the extent and use of debt and of products that can have detrimental effects.

Institutional

1. Those objectives of Islamic financial institutions that are exemplified in Islamic values and principles should prevail over economic and commercial motivations.

2. The Islamic financial sector should endeavour to expand alternative institutions and structures such as venture capital, private equity, cooperatives and others to enhance the use of equity-based contracts.

3. To manage the higher risk of equity-based financing on the asset side would require having sharing arrangements on the liabilities side. The returns given on the liabilities side should be commensurate with the risk-return profile of the portfolio on the asset side.

4. Islamic banks should introduce special funds/restricted investment accounts for use in equity-based financing. This will help to promote equity-based financing without invoking the higher capital requirement.

5. Islamic financial institutions should enhance their risk management infrastructure, which includes risk governance and risk management processes, in mitigating the unique risk characteristics embedded in equity-based financing.

6. Human capital possessing a special skillset for managing equity-based products and services should be nurtured.

Products

1. There should be more structured and holistic deliberations and debates amongst the important stakeholders, i.e., Shari’ah scholars, practitioners, economists and regulators, in developing Islamic financial products.

2. New approaches to client appraisals should be developed that depart from the predominant credit-based scoring to assessment of entrepreneurial and business capabilities.

3. Islamic financial institutions should allocate resources to study and promote innovative equity-based products. The studies should include research measuring the impact of various debt-to-equity ratios on individuals, firms and society in order to ascertain the optimum balance that minimises harm and optimises benefits.

The declaration was agreed upon and endorsed by all participants attending the roundtable. A full list of the participants may be found on the ISRA website.

Marjan Muhammad

is currently a researcher at the International Shari’ah Research Academy for Islamic Finance (ISRA). Prior to joining ISRA she was a tutor at the Faculty of Law and Syari’ah, Islamic Science University of Malaysia (USIM).

   NEWHORIZON    April to June 2013COUNTRY FOCUS

The Growth of Islamic Finance in Egypt a Hostage to Political and Economic Stability

Andrea Wharton,
Editor

A year ago this publication produced a mini profile about Islamic Finance in Egypt as part of a broader look at all of the North African states bordering the Mediterranean. In that profile it was noted that Egypt was the birthplace of modern Islamic finance, when Ahmed El Najjar opened the first Islamic bank in 1963, but for a variety of reasons the fledgling industry did not thrive. It was other countries in the region and in South East Asia who took up the mantle of Islamic finance and turned it an industry worth around $1 trillion.

At the Euromoney Islamic Financial Summit held in London in February 2013, Dr Hussein Hassan, a Shari’ah scholar involved with the committee drafting the laws for Islamic banking and sukuk issuance in Egypt, commented that since the Arab Spring, the political will to develop an environment that is conducive to the growth of Islamic finance, was there. With a population of around 84 million people, 90% of whom are Muslim, Egypt does have the potential to be one of the biggest markets for Islamic finance in the region. Recent events in Egypt have, however, halted the whole process in its tracks. What happens next will impact Egypt’s will and ability to develop an Islamic finance system in parallel to the conventional system. At one end of the spectrum there is the possibility that the army will resume its role as ‘kingmaker’ and in that case we have to assume that will not favour the creation of a financial system attuned to Islamic finance. At the other end of the spectrum there is the possibility that elections will be held in early 2014 and that a variation of the Morsi government will be returned to power, in which case we have to assume they will at some point resume their attempts to strengthen Islamic finance in the country.

The most pressing problem for any new government in Egypt is, however, the need to address the country’s deep economic problems, clearly one of the triggers for the recent unrest. One thing is absolutely certain – a failure to deliver on the economic front will probably lead to continuing unrest and instability. In these circumstances any Egyptian government, whatever its political leanings, will have to focus on getting funding from the international community and that almost certainly means concluding a deal with the IMF. A sovereign sukuk could help, but on its own is unlikely to be enough to kick start the sort of economic growth Egypt needs and indeed investors may be unwilling to participate until the situation in the country shows some signs of settling down.

Banking

Currently Islamic banks in Egypt are variously estimated to have between 3% and 5% of the total banking market in the country with only three fully fledged Islamic banks in the country – Faisal Islamic Bank of Egypt, the longest established of the three banks, the Egyptian division of the Bahrain-based Al Baraka Bank and Abu Dhabi Islamic Bank of Egypt. (Further background details about these banks are contained in Issue 183 of NewHorizon, April-June 2012.) At the end of 2012 there were a further 11 banks operating Islamic windows.

Most banking activity, conventional and Islamic, in Egypt is, however, concentrated at the corporate and investment banking levels, because 90% of Egyptian adults currently do not have a bank account and that perhaps has less to do with religious scruples and more to do with the fact that most of the population is living a hand-tomouth existence. If they are able to save any money at all, many Egyptians tend to use informal arrangements known as gama’iya, where a small group of people agree contribute a small amount each month and then take it in turns to withdraw the full sum to finance the purchase of the sort of larger items they would otherwise be unable to afford. It may well be that they use these arrangements from necessity rather than choice. In an interview with Bloomberg in late 2012 a former board member of Faisal Islamic Bank said that the bank tended to be unwilling to lend to individuals, because they feared they would default on the loans.

The Morsi government was, however, determined to strengthen the banking sector, particularly Islamic banking. Their stated intention was to raise the market share of Islamic banking to 35% of the total banking industry in five years, i.e. by 2018. They were working on a number of measures to achieve this, including raising minimum capital requirements for all banks, conventional and Islamic, which was widely expected to lead to some mergers and acquisitions particularly among the smaller banks; framing laws to regulate Islamic banks (there were previously no such laws in Egypt) and a sukuk law, which had been the subject of considerable debate.

The announcements in early 2013 by the Principal Bank for Development and Agricultural Credit (PBDAC), Egypt’s main, government-owned agricultural bank that it would be launching Shari’ah-compliant retail banking services at 18 of its 1,210 branches was perhaps a sign that the government was prepared to put its money where its mouth is. A spokesman for PBDAC said that only 1 million of Egypt’s 5.8 million farmers who owned land had borrowed from the bank. It is thought that this is due to the farmers’ unwillingness to take out conventional loans, which carry interest. PBDAC hoped that Islamic finance based on murabaha and musharaka structures would boost the numbers of borrowers to around 3 million. A small move, perhaps, but a sign that the government was not only keen to promote Islamic banking, but also that it was determined to do what it could to boost economic activity and that is key to Egypt’s future. (A more cynical view would be that the Morsi government were trying to consolidate their support among the rural poor. The truth is probably that there was a little of both motivations in their move.)

Egypt’s Economy

It is quite simple – if economic confidence is bumping around the bottom of the barrel, financial institutions get nervous and become unwilling to lend, which, of course, only exacerbates the problem, making economic recovery even more difficult. In the wake of the global financial crisis, this is a problem that has become all too familiar to many countries around the world, but Egypt is perhaps suffering more acutely than many others. The added spice in the Egyptian mix is continuing political instability.

The facts are these – growth has fallen from 6% to 1.8% since the revolution in 2011; unemployment has risen to 12.6%; inward foreign investment has slowed to a trickle; the key tourist industry is struggling to attract visitors to a country that is unstable and with the Egyptian pound under pressure, the budget deficit has widened and foreign currency reserves are about one-third of pre-revolution levels. Egypt finds itself in an intractable situation with political and economic issues so intertwined that it is difficult to address one of these elements without straying into the territory of the other. For example, Egypt currently subsidises imports of wheat and fuel to help to sustain a population that either has no job at all or exists at a subsistence level; these subsidies are one of the factors in the widening budget deficit and the depletion of foreign reserves, but if these subsidies are cut, without a concomitant increase in levels of employment, the outbreaks of civil unrest are likely to increase. (In fact, increases in the prices of electricity and bottled gas did take place and were yet one more contributory factor to the widespread discontent that triggered the latest demonstrations and the intervention of the army.)

IMF Funding

To kick start the economy and reduce levels of unemployment Egypt needs to borrow money, but that is easier said than done. One approach to the problem was an application for an IMF loan of $4.8 billion in the late summer of 2012 and agreed in principle in November 2012. Further outbreaks of violence on the streets in December put that loan on hold and with the troubles it is difficult to see the loan being granted in the immediate future. Even if it eventually goes ahead as some analysts thought it would, the price demanded by the IMF - cuts in subsidies and an increase in tax revenues - is unlikely to do anything to bring political stability. It is a real chicken and egg situation – Egypt needs investment to generate employment, but before the population feel the benefits, they are going to feel the pain and that in turn could lead to further unrest and political instability. A successful outcome to the negotiations with the IMF is critical, because other Western countries had indicated that they would be willing to lend to Egypt, provided the IMF loan is agreed.

In an interesting development at the beginning of May 2013 the ministers of planning and finance were replaced in a government reshuffle. Both of these individuals, Ashraf al-Arabi and Al-Mursi Al-Sayed Hergazy, had been closely involved in the discussions with the IMF. Although the new ministers confirmed their commitment to negotiating an IMF loan, which had been expected to be agreed by the end of May, such high-level changes at that stage were likely to unsettle the IMF. Some commentators in Egypt speculated that an IMF loan was unlikely to be concluded until the end of the year. That date is probably even further into the future now. If successful elections are held in early 2014, and that seems to be a big if at the moment, it is unlikely that an IMF loan would be able to be agreed until towards the end of 2014.

The Sukuk Law

Another approach taken by Egypt’s government to encourage inward investment was the framing of a law on sukuk. (Egypt’s government hoped that sukuk could raise as much as $10 billion per annum, which is an addition to and not an alternative to the IMF loan.) The law was passed through the upper and lower houses of the Egyptian parliament. It seemed that the next steps would be referral to the Islamic Research Council in Cairo to confirm its legitimacy and then on to the Supreme Constitutional Court and finally the President.

In early April, however, President Morsi found himself more or less forced to refer the proposed law to Al Azhar, described as Egypt’s leading Islamic authority. The new constitution apparently stated that Al Azhar must be consulted on all matters involving the Shari’ah. The problem was that the clause in the constitution relating to Al-Azhar is ambiguous and does not say whether Al Azhar’s opinions would be binding on the government or not, potentially leading to protracted political and legal wrangling. In their initial discussions on the sukuk bill Al Azhar expressed particular reservations about Article 20, which stated that the legal committee would rule on whether sukuk conformed to the Shari’ah. They believed that this conflicts with Article 4, which says that Al Azhar will rule on all Shari’ahrelated matters. In mid April local newspapers were reporting that Al-Azhar were demanding amendments to nine of the 31 articles in the bill including putting a 25 year limit on the maturity of Islamic bonds citing Islamic law, which says that investments must be ‘suitable for the lives of their owners’. They had also objected to the used of state assets as collateral for sukuk and demanded a role for Al Azhar in deciding who will sit on the body overseeing sukuk issuance.

In the event President Mohamed Morsi approved the sukuk law in early May after amendments were apparently made to meet Al-Azhar’s objections. It was not clear whether Al-Azhar had been asked to review the amended law before its approval. Sukuk issuance were to be monitored by two committees, one to ensure Shari’ah compliance and the other to oversee financial performance.

The controversy surrounding Egypt’s proposals is that the law would appear to allow sukuk, which would effectively lease the assets rather than relying on the assets to generate income to pay sukuk holders. A group of scholars associated with Cairo’s Al-Azhar have, however, expressed concern that this could lead to the authorities abusing public assets or even losing them to private investors in the case of a default. The latest draft of the sukuk law sought to placate the scholars by dividing government assets into two classes – those owned publicly by the state and those owned privately by the state. Assets publicly owned by the state would not be eligible for use with sukuk issuance, whereas-assets privately owned by would be. The problem is how do you differentiate between the two types of asset, particularly when the draft legislation offers no guidance on this issue? Egyptian commentators have speculated that publicly owned assets might include roads, bridges and canals, while privately owned government assets might include assets such as part public companies and housing developments.

The problem is that there is a historical precedent for the loss of national assets due to excessive borrowing by governments. In the 19th century Egypt was forced to sell its shares in the Suez Canal to Britain when the then ruler was unable to service the foreign debts he had incurred. The opponents of the Morsi government were likely to use this historical fact to try to derail the sukuk law if they could.

In addition to these drafting issues, there is the simple fact that international investors may view Egypt as high risk, i.e. the probability of default is higher than in countries such as Malaysia and the United Arab Emirates. Recent events will have done nothing to allay the fears of international investors, if indeed the sukuk law survives the current turmoil.

As if to underline these concerns, in the International Financial Law Review, Amr Namek, the Cairo-based general counsel for Citadel Capital, a private equity firm, sounded a note of caution on the Egyptian government’s hopes that sukuk would help them to solve their financial problems. He said, ‘The supporters of the sukuk law claim that it will generate $10 billion for the Egyptian government. My view is that Islamic Shari’ah products are only a tool that has to be backed by strong-performing assets or an investment that makes sense. Otherwise, whether you are using conventional finance or Islamic finance, investors will not take risks.’

Chicken and Egg

The fact is that Egypt is still not politically stable and the situation shows no signs of getting better anytime soon. The second anniversary of the revolution saw outbreaks of violence and civil unrest across the country with a state of emergency being declared in three cities fringing the Suez Canal. In March Egypt’s Electoral Commission cancelled the elections that were due to begin at the end of April on the grounds that the law organising the elections had been improperly pushed through without giving the Supreme Constitutional Court an opportunity to review it. Ultimately, the army intervened and what will happen next is anybody’s guess.

Without political stability it is difficult to move forward on the economic front and without economic regeneration the political situation is likely to deteriorate further. Given the situation is the IMF likely to grant Egypt the loan it so badly needs? Will foreign investors be prepared to buy into Egyptian sukuk? Can the banking industry, conventional and/or Islamic, flourish in these circumstances? It seems unlikely.

Is there light at the end of the tunnel? A trawl through the comments of experienced political commentators indicates that the answer is not yet. It seems no-one is prepared to predict how the situation will play out. Certainly the Morsi government demonstrated a will to promote Islamic finance, but that government has been ousted. Will any future government subscribe to the same policies? For the time being the financial world can only watch and wait and that is a tragedy for Egypt, which needs financial support now.

NEWHORIZON    Jamatul Thani - Sha’ban 1434FOOD FOR THOUGHT

Form and Substance

Shaikih Muddassir Siddiqui

Background

During the late 60s and early 70s, Muslim economists and scholars were searching for Islamic alternatives to interestbased financing and banking. The business of modern banking requires instruments that can produce a fixed return with a capital guarantee (FRCG). The pure mudarabah and musharakah concepts do not permit either one of them. The search led to bay‘ bi-thaman ajil, a credit sale with a mark-up over the spot price (BBA). Unlike Christianity and Judaism, early jurists of Islam (with some exceptions) did allow mark-up over the cash price in credit sales. A merchant was allowed to sell an asset for 100 cash or for 110 in a credit sale. The transaction resulted in a mode of financing where both, the capital (100) and the return (10), were fixed and agreed between the parties at the inception of the contract. Similarly, the advance payment sale (salam) resulted in a fixed saving (discount) over the cash price to the buyer who paid the discounted purchase price in full on the spot for goods to be delivered later.

Contemporary modes of Islamic financing turn every financing arrangement into a trade contract

This mode of financing was adopted as the murabaha contract around 1976 and subsequently became very popular in the Islamic banking world. The basic murabaha framework (buying first and selling with a markup later) was then replicated by IFIs (Islamic Financial Institutions) in other contracts such as forward leases, finance leases, diminishing partnerships, salam, various parallel contracts, sukuk and so on. The Shari’ah supervisory boards also allowed the LIBOR (London Interbank Offered Rate) and other interestbased benchmarks to be used in calculating the mark-ups.

Regrettably, the BBA concept (a genuine Islamic method of financing) was implemented in such a way that it has become a source of main credibility deficit, confusion and conflicts with other laws governing various aspects of life in a society.

Contemporary modes of Islamic financing turn every financing arrangement into a trade contract. As a result, the Islamic bank and its customer are made to act like buyers, sellers, lessees, lessors, builders, partners, principal and agents. The contracts they sign are not financing contracts. Often the LIBOR-based financing is dressed up by two or more commercial contracts.

A recent report, commissioned by Qatar Financial Centre Authority on Islamic finance describes this phenomenon as follows: ‘Most transactions that are undertaken in Islamic finance seek to achieve the economic outcomes which are similar to the economic outcomes achieved by conventional finance. However, to achieve these economic outcomes the Islamic finance transactions typically require more component steps than do the equivalent conventional finance transactions.’

Dispute Resolution

Modern laws of bankruptcy and insolvency and the Islamic concepts of iflas and i’sar both deal with debts and the rights and obligations of the creditors and debtors. Since Islamic finance uses trade contracts for creating debts, not all Islamic finance contracts directly result in the creation of debt. Consequently, not all bankruptcies necessarily result in defaults in the payment of debt.

For instance, the defaults of sukuk are generally reported as a default in the re-payment of debt. Yet, unlike bond-holders, the sukukholders are owners of investment certificates. Sukuk holders, in theory, are supposed to be the true owners of the underlying assets. As such, their remedy is to sell the asset and bear the risk of loss as owners of those assets. This is, however, the theory and perception. The reality in the vast majority of cases is different. Most sukuk are asset based and the sukuk holders have no recourse to assets under the terms of the underlying contracts. The commercial objectives of the originator and sukuk holders, all point to a creditor and debtor relationship, supported by provisions such as purchase and sale undertakings.

Through reading many cases that have so far been litigated in courts around the world, it is evident that in almost all cases, the courts have struggled to reconcile between the substance and form of contracts used by IFIs. Was it a true sale, lease, construction or partnership contract or a financing arrangement between the parties? Even when an Islamic contract, such as murabaha, results in a debt, it leads to discord and disagreements as to the exact amount of debt owed by the customer to the Islamic bank.

Through reading many cases that have so far been litigated in courts around the world, it is evident that in almost all cases, the courts have struggled to reconcile between the substance and form of contracts used by IFIs.

In numerous BBA cases in Malaysian courts, the determination of the amount due to an IFI in a 20 or 25 year murabaha financing contract, which ended earlier as a result of the default of the customer within a short period of signing the murabaha contract, depended on whether the contract was literally a deferred payment sale contract or a financing arrangement. If it were a sale contract, the total unpaid murabaha debt (including the IFI’s costs as well as unearned profit from financing) would be owed by the customer to the IFI. If it were a financing arrangement, the IFI would be entitled to the unpaid murabaha cost (the unpaid principal) only.

The Shari’ah Advisory Council of Bank Negara Malaysia, to its credit, is the only major Shari’ah standards setting body that has given a definitive fatwa on this issue in May 2010. It mandates Islamic banks to include an early payment discount provision in BBA and murabaha contracts. Bank Negara Malaysia is mandated to set the formula for early payment discount to alleviate uncertainties resulting from omitting this important provision from the murabaha and BBA contracts.

In Dubai, the determination by the court as to whether a leaseto- own contract was an operating lease or an instalment sale contract, determined the identity of the actual owner of the property (the IFI or its customer). This in turn determined the equitable distribution of the proceeds of the property between the IFI and its customer. If the court had held the contract to be an operating lease contract, the IFI would have been the owner of the whole property despite the fact that the customer had paid substantial numbers of instalments leading up to his ownership, leaving only a few unpaid instalments as a result of financial distress. The court, despite the title of lease-to-own, re-characterised the contract as an instalment sale.

Recently, an Islamic finance institution has filed for bankruptcy in New York, under Chapter 11. Notwithstanding that it is an Islamic financial institution and uses various Islamic financing contracts approved by its Shari’áh board, it has declared in the bankruptcy petition that all its customers are creditors and all its contracts are ‘Bank Loan’ contracts. It has also classified all mark-ups over its costs as ‘interest’ and sought to benefit from the post-petition interest freeze allowed under Chapter 11. Most probably the IFI is relying on the substance over form in its declaration of bankruptcy.

The new AAOIF standard No. 43 mainly deals with personal bankruptcies. Section 9 of the Standard, however, excludes from the pools of assets available to creditors, all funds deposited by Islamic bank customers in saving and investment accounts. As a result, in the case of bankruptcy, the depositors in saving accounts would have none of the protection granted to creditors. They would bear the risk of loss as rab-al-maal or muwakkil (depending on they have used a mudarabah or investment wakala contract to place their deposits). Whether central banks would allow an Islamic bank to deny depositors in saving accounts the same protection as that offered to current account customers is questionable. During the financial crisis of 2008, despite the terms of the saving accounts in Islamic banks, no one is reported have lost a dirham in saving accounts.

After considerable thinking and reading of the case law and articles, it is clear that the use of fictitious contracts is the main source of the lack of clarity, conflicts and the credibility deficit in Islamic finance. Unless the form and substance is reconciled, it would be very hard to rationally and consistently develop and apply the rules of iflas and i’sar to defaults, distresses and bankruptcies in Islamic finance.

A Genuine Solution

Wikipedia, after explaining the meaning of the term Contractum Trinious as ‘a set of contracts devised by bankers and merchants in the Middle Ages as a method of circumventing canon law edicts prohibiting usury’ adds that: ‘Some Muslims are of the view that the present practice of Islamic banking relies on devices similar to the Contractum Trinious as a means of working around a ban of riba (usury) in religious scripture’.

Just working around every conventional financing term sheet by using multiple trade contracts is not a genuine Islamic solution. Reputable Fiqh Academies of OIC, Muslim World League hold similar views on some of the Islamic contracts such as organised tawarruq and al-inah. In a case in the U.K. (TID v. Bloom) an Islamic financial institution has argued that an investment wakala contract, approved by its own Shari’ah supervisory board, was in reality an interest-based transaction dressed up as an investment agency contract.

We need to change the course and need to articulate a rational basis, rooted and derived from the principles of the Shari’ah for distinguishing a halal fixed return with capital guarantee and a haram fixed return with capital guarantee.

There are several reasons why we have adopted the path of fictitious contracts in the past. It is possible to take the view that the only genuine tool of financing in Islam is mudarabah or musharakah is wrong.

Similarly wrong is the view that all financing arrangements which produce FRCG are prohibited in Islam. We have failed to recognise the importance and the potential of credit sale with mark-up over its cash price (BBA) and the advance payment sale (salam) at lower than the market price, as tools of genuinely halal financing. Both forms of transactions are as permissible under the Shari’ah as mudarabah and musharakah. We failed to realise that both BBA and salam, if properly characterised and analysed, produce fixed returns with capital guarantee on day one. We are mistaken in insisting that fixed return in BBA and discount in salam, are an integral part of the price of the item sold or bought.

Most importantly, we failed to rationally articulate the difference between a haram (ribawi) fixed return with capital guarantee transaction and a halal fixed return with capital guarantee transaction. We should have compared the two sets of transactions and sought for the reason for the prohibition of FRCG in a purely loan transaction and its permission in BBA and salam.

Once we had extracted the golden Shari’ah principle for tahlil and tahrim, we should have accepted it as a genuine foundation on which to build various components of the Islamic finance industry. We should then have developed contracts which would observe the Shari’ah principle extracted for permissible FRCG without resorting to dressing up conventional contracts with fictitious sale, lease and tawarruq contracts.

After considerable thinking, it is possible to humbly submit the following reason and rationale for differentiating between a permissible FRCG and an impermissible FRCG. It can be noted that in a pure cash now for more cash later transaction, the benefit which a borrower may have received from a financier was not certain and measureable. For instance, at the time a mudarib receives funds from rab- al-maal, he is not sure if his trade will be profitable or suffer a loss. As such, it is prohibited to fix a return for rab-al-maal at the inception of the contract. Once the actual profits are known, however, then a share in the actual profit is permissible and the capital must be returned as well. In a credit sale with mark-up over the cash price, on the other hand, both parties can be certain that the receiver of finance would receive a usufruct which is both certain and measureable at the signing of the contract. For example, if one purchases a house today but pays the purchase price in one year, that person would not only become the owner of the house today, but he would also get the benefit of living in the house for one year before paying for it. The right to live in the house is certain and the benefit of living in that house is also measureable. Based on this comparison we can find the reason why the Shari’ah has considered charging an increase in financing in some cases as unjust and oppressive while allowing it in others as fair and just. The principle, it seems, can be extracted as follows:

• The Shari’ah rules prohibit a financier from charging a fixed return with capital guarantee, when the receiver of the finance is asked to pay a consideration for speculated benefit which may or may not occur.

• The Shari’ah rules permit a financier to charge a fixed return with capital guarantee when the usufruct accruing to the receiver of the financing is certain and measurable.

• The permissibility for the financier to demand a fixed return or discount must be measured by and in consideration of the usufruct and not for the time alone.

The credit sales with mark-up for time were originally used by merchants, who were selling goods in which they traded. Our next task would have been to apply these principles in the case of financial intermediation by Islamic banks.

We should have allowed the Islamic banks to write a loan contract with fixed return when the customer is getting a certain (not speculative) and measurable usufruct. The contract (sale contract with the seller of the house), which is the source of certain and measureable usufruct, should have been tied to the loan contract with the bank. The financing and sale contracts must have been an integral part of the overall relationship, without insisting on requiring the IFI to go through fictitious contracts in which the IFI ownership is mostly on paper (not registered) and does not last more than a few minutes.

What is the Difference?

Some might say, what is the difference between the two systems of financing; the one proposed here and the conventional? The following reasons are submitted:

1. It is wrong to assume that under no circumstance can a lender receive more than the amount lent. A return on a loan contract is not prohibited by the Shari’ah, per se. The Prophet Muhammad (s) not only himself paid back more than he borrowed but also encouraged others to do the same.

This proves that the mere fact of paying more than the amount borrowed or receiving more than the amount lent is not riba. One has to look at the conditions and the reasons for which the additional amount is paid or received before issuing a judgment. If the reasons and conditions under which the increase is given are permissible under the Shari’ah, then it should not be objected. For instance:

a. It is agreed among scholars that if the lender incurs actual expense in advancing a loan, then the borrower may be asked to reimburse it in addition to the amount of the loan. Thus, if one lends 100 dinar to a borrower and incurs 2 dinars in transferring the funds to him, he is entitled to get 102 dinars from the borrower.

b. Some scholars have recently allowed Egypt to borrow from the IMF (International Monetary Fund) at 1.1% interest, considering it as the administrative cost to IMF for processing and managing the loan.

c. The IDB (Islamic Development Bank) is allowed by its Shari’ah advisors to charge an increase on its charitable loans, provided it represents the actual administrative costs involved in appraising the loan application, processing and servicing it. These service charges do not make IDB charitable loans (qard hasan) interest-based loans.

d. Depositors in current accounts in Islamic banks (who are considered lenders) do not receive a return in cash. They receive, however, a host of in-kind benefits and services from the bank free of charge. Most Islamic banks do not charge for the safe keeping of money, use of checks, credit cards service, ATM machines accessible around the world and free electronic transfers, just to name a few. No one considers these additional in-kind services received by a depositor as riba resulting from lending to the Islamic bank.

2. RCG in the conventional banks is for time alone. Time alone is not a valid consideration for which compensation can be charged under the Shari’ah. FRCG under the proposed solution is for the usufruct. A charge for usufruct is permitted in the Shari’ah.

3. The use of LIBOR as a benchmark is a charge for time. Its use in sale contracts does not change the substance and the nature of the charge. It should not have been allowed by scholars. If FRCG on Islamic finance contracts were based on usufruct, a genuine and workable Islamic benchmark based on usufruct would have been developed long time ago, removing one of the most contentious and criticised practices in Islamic finance.

4. It has to be acknowledged that it appears the two financing systems, the conventional and the proposed, look similar. Once closely examined and developed into contracts and standards, however, the difference between the two can be rationally explained and consistently followed without creating conflicts and tensions between Islamic finance contracts and other laws needed for a modern society.

Efficient and workable bankruptcy codes are as important for the economic wellbeing of a society as hospitals are for treating human ailments and diseases. The present bankruptcy codes, with only slight changes to comply with the principles of the Shari’ah, can be developed to adequately deal with Islamic financial distresses and defaults. The challenge does not lie in developing a workable and Shari’ah compliant bankruptcy code; the real challenge lies in changing the modes of Islamic banking and financing to make them rationally fit with other laws, which are genuinely needed to organise and govern an Islamic society.

Al-Imam ibn al Qayyim states in A’alam al-Muwaqq’in ‘an Rabb al’alamin:

‘The foundation and components of the Shari’ah are based on the benefits of the people in this world and in the Hereafter. Thus it is the ultimate source of justice and benevolence; it is all gains and all wisdom. Thus any scheme which diverges from justice to oppression, from mercy to its opposite, from benefit to harm and wisdom to nonsense; it is not from Shari’ah even if is inserted in it by construction’.

Dr Murat Ünal

Shaikh Muddassir Siddiqui is uniquely qualified both as a Shari’ah scholar and as a U.S. trained attorney. He is a member of the AAOIFI Shari’ah Standards Committee; the Fiqh Council of North America and a Research Fellow at the International Shari’ah Research Academy for Islamic Finance, in Malaysia. Shaikh Muddassir is a member of New York Bar and a registered foreign lawyer with the Solicitors Regulation Authority (SRA), in the U.K. He has extensive experience in advising on transactions involving Shari’ah-compliant financing.

NEWHORIZON    April to June 2013Under the Microscope

Islamic Finance and Shari’ah Compliance: Reality and Expectations

This article is based on a lecture given by Dr Frank Vogel at the London School of Economics (LSE) on 27 February 2013. The lecture was jointly organised by the LSE’s Department of Law and the Harvard Islamic Finance Project.

Preamble

The title of this lecture suggests there is some divergence between Islamic finance and the requirements of the Shari’ah both in reality and expectations. Dr Vogel commented that the reality in this dystopian world will never be the same as the ideal of the Shari’ah, but that he would focus in the lecture on expectations. In particular he set out to address questions such as are we expecting the industry to achieve Shari’ah compliance, but in the end expecting it to do so through means and instrumentalities that will be inadequate. He further asked whether, if by focusing on these instrumentalities, we are neglecting other means, so that our expectations will inevitably be disappointed, perhaps to an even greater extent than would be expected.

He indicated that his own interest in Islamic finance is as a comparative lawyer specialising in contemporary applications of Islamic law and finance as one of the areas in which it is applied. His own view is that Islamic law is not just as a set of rules; it is a legal system. Today Shari’ah is often seen as a set of religious strictures, dos and don’ts, enjoined on the faithful, but it needs to be remembered that it has always been much more. It was a justifying norm for the day-to-day legal and constitutional system of myriad states covering much of the known world for more than a millennium. Does that history have any lessons for us today in achieving compliance in Islamic finance?

The Shari’ah

Shari’ah is not just a legal code; it is a divine template for all of human life for all time, which includes the economic, financial and commercial aspects of life, not just in a legal sense, but also in an ethical sense, as well as objectives, guidelines and institutions for the larger economy and society. It addresses not just individual believers but also groupings of human beings – communities, societies, states and the Muslim nation, even humanity at large. The teachings of Shari’ah on trade, finance and the economy are profoundly intertwined with all of its principles and laws for other aspects of life such as ritual observance, individual morality, family life, community, law, constitution and governance.

Shari’ah is often equated with the jurisprudence of scholars, the fiqh. Over the centuries Muslim scholars have worked hard to discern what God’s commands are in relation to human actions and to produce a set of laws based on Shari’ah. The product of this collective work is the fiqh. It is recognised that because fiqh results from human actions, it is subject to imperfections and that is evident in the diverse interpretations of the scholars.

Fiqh

Fiqh emerged from the work of private scholars; it was not laid down by the state and it took some centuries for it to be unequivocally adopted by the state as its law. Until that point perhaps the state rather than the scholars had the upper hand in determining what Islamic law was. Given its origin in the private sphere, even now fiqh concentrates more on the private and civil sphere with rules on matters such as cleanliness, lawful food, marriage and property rather than the public and collective aspects of society such as the criminal law and taxation.

On public and collective issues authority tends to be delegated to decision makers other than the scholars, usually the ruler or state, as long as Shari’ah principles are respected. These could be described as fiqh constitutional principles and effectively this means there are many people other than scholars, notably the ruler and state, responsible for implementing fiqh principles.

The teachings of Shari’ah on trade, finance and the economy are profoundly intertwined with all of its principles and laws for other aspects of life such as ritual observance, individual morality, family life, community, law, constitution and governance

This constitutional delegation is subject to conditions. One of the most important of these conditions concerns the state, siyasa al- Shari’ah, meaning governance according to the Shari’ah. This delegates authority to those in charge of public functions to act in their own discretion subject to two main conditions that actions should be in the interests of general welfare and that they should not offend the general rules and principles of Shari’ah. The application of these general rules and principles by the state or ruler is, however, very different from the method used by scholars, who rely first and foremost on the interpretation of text, while those exercising siyasa rely on utility and consult texts only to avoid fundamental contradiction with them.

A second important constitutional principle on which fiqh relies for regulating many forms of collective action and for adapting its age-old rulings to time and circumstance is custom and customary laws, which are acceptable only if they do not contradict Shari’ah principles. Unfortunately these days, because most of the Shari’ah system was dismantled during the colonial era and systems based on Western laws ushered in, it is too easy to forget the full scope of the Shari’ah and to focus too single-mindedly on those aspects of fiqh that relate to individuals and their private lives. It is also easy to forget that there are mechanisms for the determination and enforcement of laws under Shari’ah other than that of scholars advising individuals.

Islamic Legal History

Finally what is the relevance of Islamic legal history for Islamic finance? One intriguing question is, if we are going to study historic fiqh, why do we not look at the systems of application the scholars had in mind when they wrote the fiqh? What mechanisms did those scholars develop in order to ensure fiqh was applied and enforced? Is it even possible to apply fiqh without that background understanding? It is essential to understand the context of historic fiqh, if it is going to be applied to the regulation of finance.

At the micro level, Islamic financial regulation was about individual scholars advising members of the community or civil society generally about financial transactions, deriving that advice from Islamic scripture. At the level of civil society many institutions such as those involved with zakat were run by scholars.

At the business/market level, in addition to Shari’ah principles, customs and the ethics of the merchant community also played a part, with the trades and professions themselves taking the responsibility for applying the rules/ laws, which in some instances imposed even higher standards than fiqh. At the macro level, for example fiscal and monetary policy, rulers or the state, through siyasa al-Shari’ah, had the right to issue decrees in the interests of utility. Clearly there were many different methodologies and players, not just Islamic scholars.

The Contemporary Scene
The Role of Scholars

Are there any parallels that can be drawn between historic and contemporary players? It is worth mentioning maqasid al-Shari’ah, which falls within fiqh. This is an extremely powerful legal methodological doctrine, which was first stated comprehensively in the 14th century. It calls on scholars to conduct a profound study of all the developed corpus of Islamic fiqh, seeking to identify by induction the purposes and objectives for which God revealed this law. The doctrine claims that once these objectives are known, the scholars should, whenever they are deriving a fiqh ruling from the revealed texts, choose that interpretation, which according to their reasoning and a consideration of the consequences of that ruling, best advances God’s objectives. This doctrine goes a long way to shifting the emphasis from a system that merely interprets texts to one which focuses on human reasoning and an appreciation of the consequences of legislation. One of the things that is often misunderstood or forgotten about historic Islamic legal systems and even enforcement is the extent to which they were privatised with a great deal of legislation being accomplished by scholars in their private capacities. Even adjudication was done by scholars who, in the law they applied, took their cues from other scholars and not from the state. Today’s Muslims are familiar with such private law making, but only in their private lives by and large. In practically all Muslim legal systems the state does not interfere.

One of the interesting things about Islamic finance is it revives the idea of applying Shari’ah beyond the purely personal sphere.It could, however, be difficult for scholars to advise individuals about commercial transactions while taking into account the macro perspective, e.g. the macro consequences of the ruling for general utility.

The scholar’s focus is on the micro level of particular disputes or transactions; in this context the scholar would not be particularly competent to decide on macro considerations. In the past scholars did concern themselves at macro levels, but in roles other than making decisions and giving advice on the level of individual transactions.

It may be too much to hope that simply by applying the rules of fiqh al-muamalat in banking and insurance it would be enough to usher in the grand Islamic economic system. Certainly Islamic legal systems in the past did not assume this would be the case.

One of the most basic principles of fiqh is that in matters of muamalat (financial transactions) the original ruling is permissibility, i.e. acts are permitted unless expressly forbidden by Shari’ah. If they are permitted, but those acts are to be restricted or forbidden on the grounds of some sort of utility, it is not ordinarily the scholar’s role to do so while advising individuals, but rather the role of the state acting on siyasa al-Shari’ah principles. It is worth noting at this point that all the criticisms just noted apply to scholars advising individuals on Islamic transactions. Indeed for every one of these aspects of their work, which reflect an age-old pattern of the application of Shari’ah, scholars have been strongly criticised. For example, it has been claimed that they should not be deciding on matters that could have a huge macro impact and that their focus on circumstances is too micro; that they need to broaden their views; that they should have the skills that would enable them to consider macro goals and help achieve them; that they are too prone to permissiveness, i.e. what is halal and not on what would advance the interests of Muslim society and that scholars should encourage or require the institutions they advise to serve macro goals such as public utility. These criticisms point to real problems with the modern system of Shari’ah governance. How then did old Islamic legal systems fill these gaps and deal with these problems?

Critics may be focussing too much on the micro level where the scholars function and not addressing the macro issues surrounding governance. It may be too much to hope that simply by applying the rules of fiqh al-muamalat in banking and insurance it would be enough to usher in the grand Islamic economic system. Certainly Islamic legal systems in the past did not assume this would be the case.

Private Sector Institutions

Beyond the scholars, the Islamic financial system interacts with other individuals and bodies such as lawyers, banks ratings agencies and financial markets. The norms applying here are those of the conventional system. Perhaps there were analogues in past Islamic legal systems for dealing with the influence of private sector institutions and practices on Islamic finance. An example would be the common trade practices developed in the Mediterranean in medieval times. The flow, of course, may have been in the other direction with Islamic practices influencing Europe.

A more important question, however, might be, outside the international sphere, in the home countries of Islamic banks, are the various functions being performed by non-Islamic entities such as banks and law firms, supplanting functions once part of the old Shari’ah system, that supported and complemented the application of the fiqh commercial law? To what extent should reliance on external systems of law, accountability and finance eventually give way to similar systems framed around Shari’ah? Is Islamic finance in danger of becoming merely a disembodied algorithm, a set of special, consumer-dictated restrictions that are otherwise indistinguishable from the global conventional financial and legal systems? One has to ask if Shari’ah were taken as the basis for accountability, financial design and dispute resolution, would the resulting systems be significantly different from the conventional ones.

Industry Bodies

The next level is industry bodies and they represent a very impressive development in Islamic finance. Over the last few decades there has been a proliferation of international, self-regulating organisations such as AAOIFI, IIFM and IFSB, who are analogous to the historic customs of the market place with its merchant and trade guilds. The question is, are these bodies too content to leave issues of Shari’ah compliance to the scholars, supplementing scholars’ criteria with those taken from the conventional industry, regulatory and self regulatory. Are they taking on the responsibilities of similar institutions in the past and doing so at a more macro level than the scholars? If the industry is to uphold higher ethical standards to protect customers or more broadly promote social interests, should that not be the responsibility of these organisations rather than of the scholars? If Islamic finance is at a critical turning point as many claim, perhaps the assessment of the state of the industry and its future direction should be the responsibility of these industry bodies.

Self Regulation of Scholars

Fiqh scholars in the past evolved very elaborate systems of self regulation. The most important institution was the legal school, within which there would be informal hierarchies of scholars with those at the highest levels serving as leaders of society representing both Shari’ah and the general population in the councils of the ruler. The high-level scholars would issue fatwas, which strongly influenced lesser scholars and judges and they could exert pressure on other scholars by disciplining them. Such elite scholars were in the best position to consider the larger needs of society and the legal system, taking the Shari’ah and general utility into account when issuing fatwas, which had near legislative effect.

Through these schools of law scholars were able to make their scholarly law sufficiently stable and predictable, while retaining the ability to respond to changes in society, so that they could serve the legislative needs of that society in the civil sphere. This effectively deterred the state from interfering to any great extent in the arena of civil law.

Regulators

The regulators of financial institutions also have a historic analogy in the form of the muhtasib, an officer charged with policing public places to enforce fiqh rulings and public morality as well as market regulations. States in the past did not simply rely on self regulation to uphold ethical standards, they enforced them. In other words state enforcement extended beyond the rules of fiqh and the reach of the courts.

Courts enforcing financial contracts applied the entirety of fiqh rules in terms of contract, liability, damages and burden of proof. This is true today only in Saudi Arabia. Today most large Islamic finance transactions specify enforcement in the US or the UK.

The Government

Much law began from the top, from the government, supplementing and filling the gaps in Shari’ah through the authority of the ruler.

Conclusions

Too often in Islamic finance the role of Shari’ah is understood as the application of fiqh almuamalat to the acts of private individuals and institutions at micro levels, while too much of the rest is decided by conventional standards. Fiqh al-muamalat was, however, written only as part of a wider legal system.

Former Islamic legal systems assigned roles to scholars in addition to delivering micro compliance, involving them at higher or macro levels of legislation, regulation and policy. Actors other than scholars also performed essential economic, Shari’ah roles. They did not apply scholarly methods, but they were influenced by Shari’ah principles and the advice of scholars.

The full evaluation and implementation of utilities and divine objectives demands not only the textual perspective, but also macro and temporal knowledge and expertise, which private scholars do not usually command. Similarly, any standards beyond the scope of a private fatwa, such as Shari’ah ethical, prudential and welfare standards, need to be articulated and enforced by public and private entities in addition to scholars, who merely perform advisory roles.

NEWHORIZON    Jamatul Thani - Sha’ban 1434IIBI LECTURES

IIBI Monthly Lecture Series – February and March 2013

February: The Tax Treatment of Islamic Finance in the MENA Region

Mohammed Amin’s lecture was based on a study of taxation practices relating to Islamic finance in the MENA region. The study was sponsored by the Qatar Financial Centre Authority region working with the Washingtonbased International Tax and Investment Centre and Ernst & Young (E&Y). It was designed to establish how common Islamic finance structures were treated in the region, with a particular focus on cross-border transactions, to identify tax obstacles and to make policy recommendations. The study also looked at Malaysian practices to provide a comparison with the MENA region.

Mr Amin began the lecture with a disclaimer, pointing out that tax was a complex subject and the contents of the lecture did not constitute professional advice.

Study Scope and Methodology

The study is based on responses from Egypt, Jordan, Kuwait, Libya, Oman, Saudi Arabia, Turkey and both the main territory of Qatar and the Qatar Financial Centre (QFC), whose rules differ from those of the main territory. As E&Y dealt with the distribution and return of questionnaires, Mr Amin stressed that he had no responsibility for the omission of other MENA countries, some of which such as Bahrain, and the United Arab Emirates have a major presence in Islamic finance. Information was obtained from Malaysia to provide a comparison and implicitly from the UK, given Mr Amin’s status as a UK tax expert.

The focus was on direct taxation such as income tax, corporation tax and capital gains tax. Value added tax (VAT) and other consumption taxes and zakat were excluded. The study focussed on four structures commonly used in Islamic finance – commodity murabaha/tawarruq, which are equivalent to conventional loans; ijarah sukuk (onshore and offshore SPVs), which are equivalent to tradable bonds; salam, which is equivalent to committed forward purchasing of goods and istisna, which is equivalent to construction finance.

The questionnaire went into considerable detail so that respondent could clearly understand what we were asking. The financial structure was explained both verbally and diagrammatically. An example of one of the diagrams is shown here.

There were a total of 68 questions about law and tax treatment in each host country, including tax treaty implications. For all the structures the survey looked at the impact of tax treaties and transfer taxes. For commodity murabaha it also looked at the deductibility of customers’ expenses; whether the transaction creates a taxable presence for a foreign bank and withholding tax. For ijarah sukuk it looked at the taxation of the transfer of the building to the SPV; deducibility of rental expense; the income tax position of the SPV; withholding tax on payments to investors; taxation on the sale of sukuk certificates and the taxation of the SPV at the closing sale of the building back to the original owner. For salam and istisna it looked at whether the transaction created a taxable presence for the foreign bank and withholding tax. The answers to these questions are critical to an understanding of whether it is financially viable to do certain transactions in any given country or whether the tax laws make the cost prohibitive.

Survey Results

Out of all the countries surveyed only 1.5 have legislation for Islamic finance. Turkey has rules purely for sukuk transactions and then only if the SPV is in Turkey. The other place that has rules on sukuk is the Qatar Financial Centre, although the rest of Qatar does not. None of the other MENA countries in the survey have rules despite the fact that most of them have for some time had Islamic governments ostensibly keen to support Islamic finance.

In terms of structures, in some countries you just cannot do transactions internationally. For example, in Libya you are not allowed to have a foreign bank buy something in Libya and sell it to another Libyan.

All the countries surveyed will give tax relief for finance costs; however there is no complete clarity about when you get the deduction. Let us say you do a murabaha transaction that is 18 months long, are the finance costs taken on the day you do the transaction; is it spread over the 18 months? There is no consistency about when you get the deduction.

Although only Turkey and the Qatar Financial Centre have rules on sukuk, there are exemptions in other countries. For example, in Kuwait has taxes but they do not apply them to transactions where the company is wholly owned by GCC shareholders, which of course includes Kuwaiti shareholders. Apart from such exemptions and Turkey and the QFC, if you try to do a sukuk transaction the taxes “kill you” making it prohibitively expensive to do them. Some countries such as Saudi Arabia have done sukuk transactions, but it is likely that this is a function of things such as special government dispensations. The overwhelming message is that the tax systems of these countries are so unsophisticated that they simply have not thought seriously about Islamic finance.

Malaysia and UK Comparisons

Malaysia and the UK have thought about Islamic finance in a serious way; they have addressed the tax issues and equalised the treatment of Islamic and conventional finance. Malaysia and the UK have, however, done this in completely different ways. In Malaysia, a Muslim majority country with an explicit recognition of Islam, the key message is that you have to have government pre-approval of the Islamic finance transaction through one of the approved, standardised transactions that they have defined. If you fall within that defined transaction structure, then you get favourable tax treatment.

The UK’s approach is completely different. The UK is a secular country that does not want to have religion in its tax code; legislation is religiously neutral. The UK looks at what Islamic bankers do; analyses the transactions in great detail and then finds a way of reproducing those transactions in normal law without any reference to Arabic or religion in religiously-neutral language. The drawback is that it takes a lot more drafting, a lot more words and you can end up with something that makes sense only to tax lawyers. Malaysia and the UK both get to tax neutrality but in completely different ways.

Mohammed Amin

Mohammed Amin is an Islamic finance consultant. Previously he was a partner in PricewaterhouseCoopers LLP and led their Islamic finance practice in the UK. He is a chartered accountant, a chartered tax adviser and a qualified corporate treasurer; a Council member of the Chartered Institute of Taxation and a member of Editorial Advisory Board of New Horizon, the magazine of the Institute of Islamic Banking and Insurance Amin has spoken on Islamic finance in over 20 cities covering every continent except Antarctica. Many of his articles and presentations on Islamic finance can be found on his website www.mohammedamin.com.

Policy Recommendations

The Malaysian model is far more appropriate for the Middle East and North Africa than the UK model for several reasons. Firstly we are talking here about Muslimmajority countries, which do not have a problem about recognising Islam in their legal systems. It is feasible, therefore, to have central certification of Shari’ah transactions, (which actually these countries generally do not have) and it then becomes quite straightforward to draft tax laws.

Where Next?

Assuming that sponsorship is forthcoming, it would desirable to have a second phase of this study, which would try to get responses from those countries that did not participate in this study. It would also potentially look at other structures and focus on consumption taxes such as VAT and zakat. If tax laws cannot be made to work for these consumption laws as well, then sukuk, for example, become difficult.

When the results of the survey were presented in Oman, there were some useful comments from the Saudi tax administration, because they have a single government department responsible for tax and zakat. It is essential to determine how zakat should be applied in Islamic finance transactions and get a model that works, at least within a single country, so that a conventional financial transaction and an Islamic one get the same zakat treatment.

A second phase would also take a closer look at double tax treaties and at how Islamic finance is regulated. Should Islamic banks be regulated in the same way as conventional banks or are different regulations needed? The UK model is crystal clear here; it regulates Islamic banks in the same as it regulates conventional banks. As far as the UK is concerned they are all just banks.

Shari’ah governance would be another strand of a second study. What models do these countries apply? A gut feeling is that they do not have a model.

The value of this report is that it is based on hard facts. We can say meaningful things about what happens in these countries.

March: Form over Substance in Islamic Finance

Shaikh Muddassir Siddiqui addressed the issue of whether Islamic finance is really just the reverse engineering of conventional finance, designed to appear to be Shari’ah compliant. To achieve this appearance of Shari’ah compliance contemporary modes of Islamic financing turn every financing arrangement into a trade contract with multiple levels, which in turn leads to problems when disputes arise and courts have struggled to reconcile between the substance and the form of contracts used by Islamic financial institutions. He concluded that the use of fictitious contracts is the main source of the lack of clarity, conflicts and the credibility deficit in Islamic finance.

He went on to propose potential solutions to the problem through permissible fixed return capital guarantee transactions, which would result in clarity both in the Shari’ah principles and in their application; harmony between form and substance and between rhetoric and action; the advancement of the true objectives of Shari’ah and easier dispute resolution, because contracts have fewer steps. The content of his lecture is covered in depth in a separate article in this issue, ‘Form and Substance’.

NEWHORIZON    April to June 2013IIBI NEWS

Diary of Events

May

13 14: 3rd Annual World Islamic Finance Conference, Dubai
Key topics at this conference will include standardising global Islamic banking regulations, building a robust regulatory framework for Islamic finance and updating and upgrading information technology to enable growth.

Contact: Karthik Naik
Tel: ++9714 609 1570
Email: karthik.naik@fleminggulf.com www.fleminggulf.com

16-17: 10th IFSB Summit, Kuala Lumpur
The conference titled ‘The Future of the Islamic Financial Services Industry: Resilience, Stability and Inclusive Growth’, hosted by Bank Negara Malaysia, will be held in Sisang Kijang, Kuala Lumpur a centre of excellence for banking in the region. The keynote address will be given by H.E. Dr Ahmad Mohamed Ali Al-Madani, President of the Islamic Development Bank. The conference programme is dominated by discussion of global regulation and its impact on Islamic finance, as well as cross-sectoral regulation within Islamic finance.

Contact: Yazmin Aziz
Tel: +603 9195 1426
Email: yazmin@ifsb.org www.ifsbmalaysia2013.com

27-28: 9th Annual World Islamic Funds and Financial Markets Conference, Bahrain
This year’s conference will focus on the issues of overcoming the challenges facing the Islamic asset management industry and will analyse key initiatives that need to be taken to broaden the international base of Islamic investments. Sessions will include discussions of how to adapt new global financial standards to the Islamic investment industry, improving the competitiveness of Islamic funds, identifying the main drivers for growth in the Islamic investment industry and improving standardisation across Islamic capital markets.

Contact: Edwin Johnson
Tel: +9714 343 1200
Email: edwin@megaevents.net www.megaevents.net

June

3-5: 4th Annual World Islamic Banking Conference: Asia Summit, Singapore
The theme for this year’s conference is ‘Bridging the World of Islamic Finance: Boosting International Linkages and Cross- Border Deals’. Key topics will include the role of Islamic finance in facilitating inter-regional trade and investment flows, supporting the further growth of Islamic finance in Asia and internationally, internationalising Islamic capital markets, Sukuk as a driver of cross-border financial flows, reforming the regulatory and supervisory framework to enhance global connectivity and promoting international Shari’ah convergence to support industry globalisation.

Contact: Sophie Maclean
Tel: +9714 343 1200
Email: sophie@megaevents.net www.megaevents.net

10-11: 4th Asia Islamic Banking Conference, Kuala Lumpur
This conference will cover issues such as strategic marketing, corporate and retail banking and human capital issues in the Asia Pacific and surrounding regions. There will be a particular focus on Islamic finance Malaysia, Thailand and Sri Lanka. Speakers include Faizal Salieh, CEO and Managing Director of Amana Bank, Sri Lanka’s only licensed Islamic commercial bank and Shah Fahad Yousufzai, Vice President and Head of Strategic Marketing and Product Development at the Islamic Bank of Thailand.

Contact: Karthik Naik
Tel: ++9714 609 1570
Email: karthik.naik@fleminggulf.com www.fleminggulf.com

12-13: 7th Annual Sukuk Summit, London
With a keynote speech by the Lord Mayor of London this two-day conference will take a look at a wide range of sukuk markets and opportunities including sessions on opening up new markets in Europe and Africa; the implications of Turkey’s debut sukuk and the potential impact of Kazakhstan’s sovereign sukuk for neighbouring countries.

Contact: ICG Events
Tel: +44 (0)20 8200 9002
Email: info@icg-events.com www.sukuksummit2013.co.uk

September

13-15: 7th Annual Three Day Workshop, London

Titled ‘Structuring Innovative Islamic Financial Products’, this annual fixture has traditionally been held in Cambridge. This year it moves to London and is being hosted by Ernst & Young UK and supported by AAOIFI Bahrain, ISRA Malaysia and CISI UK. The three-day workshop in London will familiarise participants with issues and best practices with regard to structuring Islamic financial products, giving particular attention to improving and updating the understanding of the Shari’ah requirements and the moral and social objectives during the product development cycle. The workshop will be led by Dr Salman Khan, head of the Shari’ah office in a leading GCC bank.

Contact: Farhan Quadri
Tel: +44 (0)20 7245 0400
Email: farhan.quadri@islamic-banking.com www.islamic-banking.com

October

29-31: 9th World Islamic Economic Forum, London

This will be the first time this event has been held in Europe. It will take place at London’s Excel Centre and the organisers have indicated that the format will be adapted to increase the level of delegate participation. Islamic finance is just one strand in this event which also covers topics such as infrastructure development, technology and education. Programme details are not yet available.

Tel: +603 2163 5500
Email: hosted@meftec.com www.wief.org

NEWHORIZON    Jamatul Thani - Sha’ban 1434IIBI NEWS

IIBI Awards Islamic Finance Qualifications

In order to offer wider choice to potential applicants, IIBI launched its Diploma in Islamic Banking (DIB) by distance learning in January, 2010. The course builds candidates’ knowledge of Islamic banking concepts as well as their practical applications. It supports candidates seeking a career in Islamic banking and also their career progression in the Islamic finance industry.

Candidates having a graduate degree may take up the IIBI Post Graduate Diploma in Islamic Banking and Insurance (PGD), however those who wish to build a good foundation of Islamic banking concepts and operations, may opt to take the DIB course and later on progress to the PGD. DIB holders wishing to take up the PGD course will get an exemption from some of the Post Graduate Diploma modules.

Post Graduate Diploma in Islamic Banking and Insurance (PGD) Awards

To date students from more than 80 countries have enrolled in the PGD course. In the period January to March 2013, the following students successfully completed their studies:

► Andrew Lee, Singapore

► David Robinson, Key Account Manager, Aviva, UK

► Asif Mohamed, Senior Executive – HR and Administration, Amana Takaful (Maldives) Plc, Maldives

► Omar Paloba, India

► Muhammed Kaseem Adegbola, Nigeria

► Ahmer Ammar Usmani, Analyst, President’s Office, Gas Arabian Services Ltd, Saudi Arabia

► Afshan Patel, Oman

Diploma in Islamic Banking (DIB) Awards

Students from 23 countries have enrolled on this course so far. The following students completed their studies in the period January to March 2013:

► Ahmed Mohamed Ibrahim, Customer Relations, Takaful Insurance of Africa, Kenya

► Amir Maqbool, Marketing Specialist, Islamic Development Bank, Saudi Arabia

► Mariam Maqssod Ahsan, India

► Mudhakkir Abdulhamid, Legal Assistant, Equity Bank Ltd, Kenya

► Muhammadh Alfin Mohamed Omar, Underwriting Officer, Abu Dhabi National Takaful, UAE

► Sadiq Abubakar, Reporter, Nigerian Television Authority, Nigeria

► Yerbolat Kuanyshev, Lawyer, Batt LLP, Kazakhstan

Omar Paloba

Omar Paloba I liked many things about the course. The course was new and unique. The coordination of the course was excellent even though it was a long-distance course

 Ahmer AmmarUsmani

Ahmer Ammar Usmani The course provided me with an insight into a topic that is most relevant for me as a finance professional, specially being a Muslim. We (not only Muslims) need to know how the world can benefit from the adoption of Islamic finance and how it can be a saviour at times of distress. In particular, Islamic insurance was an eye-opener for me. I never knew it worked that way. It has strengthened the feeling of mutual help and cooperation and re-emphasised time and again that we need to put social causes higher than our own selfish motives.

NEWHORIZON    April to June 2013 BOOK REVIEW

‘Risk Management for Islamic Banks’

Dr. Rania Abdelfattah Salem. Publisher: Edinburgh University Press (2013)

This book was reviewed by Warren Edwardes, who runs Delphi Risk Management, the financial innovation and risk consulting, expert-witness and training firm. His ‘Key Financial Instruments’ (FT Prentice Hall) includes an Appendix on Islamic Banking. Edwardes is a Governor of the IIBI and has published widely and is a frequent speaker, moderator and chairman on Islamic finance.

When I review a book the first thing I do is take a quick flick through the work in two minutes. It appears on a two-minute scan that the book is written by an academic; under the direction of an academic and for an academic audience. The structure and style look very much like a thesis which could well have been the intention and original source of the text.

On reading the book a bit more carefully my initial thoughts were borne out. The book is indeed appropriate for an undergraduate or indeed a Master’s degree course in Islamic banking and finance. There seems to be little evidence that the author has actually worked for a significant amount of time in a commercial bank’s risk management or asset/ liability management department. Note that I have carefully avoided doing any research into the author’s background for fear of coming to a prejudiced opinion about the work itself rather than the author whom I do not know.

Bank risk management, as we have seen over the past few years, is not just about following the regulators’ rules carefully and dutifully. Compliance with Basel does not make for a safe bank. A risk manager has to go way beyond Basel and bring it down to the dayto- day life of the bank.

I think of risk management like driving a car on a motorway. Tyres – checked; insurance – checked; annual inspection – checked; lights – checked; windscreen fluid and wipers – checked; hands free phone system – checked; GPS set before driving off – checked; alcohol free – checked of course. So everything seems to be working well with the car and no alcohol has been consumed, but I am tired as I was when writing this book review into the early hours of the morning and having just had a good meal. There could be an inspection for alcohol on the breath and in the blood, but is there an inspection for the alertness of the driver? No there isn’t.

So getting back to bank risk management, does following Basel faithfully make for a safe bank? Plainly and simply, no it does not. Basel is a useful and essential compliance tool - but it is an inadequate substitute for basic experience and common sense.

The author shows evidence of being well read on the subject. References to other works are abundant by way of frequent quotations. In good academic text-book style most points come with identification of the source of the comment, but there is little feeling that the author is writing from personal banking experience. The book lacks personal insight and anecdotes. The overall impression is that the author has carried out an in-depth literature survey and is reporting on it.

In 2.2 Risk Management Challenges in Islamic Banks – ‘five main points’ are outlined, but these exclude what perhaps is the greatest risk to Islamic banks – Shari’ah risk leading to reputational risk, i.e. the risk that a product with Shari’ah board approval could be deemed expost to be non compliant by the market thus damaging the reputation of the institution in the market. We have seen such a case in the recent past. Liquidity Risk, though, is one of the five points mentioned and I agree that it represents a major weak link in Islamic banking.

The book will get readers up to speed in understanding the basics and help them pass their university examinations in risk management. That may well achieve the author’s and publisher’s aims, but the book does not bring the subject of risk management to life. So do not regard the reading of the book as a key to prudent Islamic bank risk management. That will come from taking what was learnt from the book and adding a thick layer of scepticism and experience of unpleasant surprises.

Book Review
NEWHORIZON    Jamatul Thani - Sha’ban 1434GLOSSARY

arboun
An Islamic version of option, a deposit for the delivery of a specified quantity of a commodity on a predetermined date.

bai al-ina
This refers to the selling of an asset by the bank to the customer on a deferred payments basis, then buying back the asset at a lower price, and paying the customer in cash terms.

commodity murabaha
A murabaha contract using certain specified commodities, through a metal exchange.

fatwa
A ruling made by a competent Shari’ah scholar on a particular issue, where fiqh (Islamic jurisprudence) is unclear. It is an opinion, and is not legally binding.

gharar
Lit: uncertainty, hazard, chance or risk. Technically, sale of a thing which is not present at hand; or the sale of a thing whose consequence or outcome is not known; or a sale involving risk or hazard in which one does not know whether it will come to be or not.

Hadith
A record of the sayings, deeds or tacit approval of the Prophet Muhammad (PBUH) halal Activities which are permissible according to Shari’ah.

haram
Activities which are prohibited according to Shari’ah.

ijara
A leasing contract under which a bank purchases and
leases out a building or equipment or any other facility required by its client for a rental fee. The duration of the lease and rental fees are agreed in advance. Ownership of the equipment remains in the hands of the bank.

ijara sukuk
A sukuk having ijara as an underlying structure.

ijara wa iqtina
The same as ijara except the business owner is committed to buying the building or equipment or facility at the end of the lease period. Fees previously paid constitute part of the purchase price. It is commonly used for home and commercial equipment financing.

istisna
A contract of acquisition of goods by specification or order, where the price is fixed in advance, but the goods are manufactured and delivered at a later date. Normally, the price is paid progressively in accordance with the progress of the job.

maysir
Gambling – a prohibited activity, as it is a zero-sum game just transferring the wealth not creating new wealth.
mudarabah
A form of business contract in which one party brings capital and the other personal effort. The proportionate share in profit is determined by mutual agreement at the start. But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour.

mudarib
In a mudarabah contract, the person or party who acts as entrepreneur.

murabaha
A contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank which then sells them to the client at an agreed mark-up. Repayment is usually in instalments.

musharakah
An agreement under which the Islamic bank provides funds which are mingled with the funds of the business enterprise and others. All providers of capital are entitled to participate in the management but not necessarily required to do so. The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in proportion to his contribution

musharakah, diminishing
An agreement which allows equity participation and provides a method through which the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset to the participants.

qard hasan
An interest-free loan given for either welfare purposes or for fulfilling short-term funding requirements. The borrower is only obligated to pay back the principal amount of the loan.

rab-al-maal
In a mudarabah contract the person who invests the capital. retakaful Reinsurance based on Islamic principles. It is a mechanism used by direct insurance companies to protect their retained business by achieving geographic spread and obtaining protection, above certain threshold values, from larger, specialist reinsurance companies and pools.

riba
Lit: increase or addition. Technically it denotes any increase or addition to capital obtained by the lender as a condition of the loan. Any risk-free or ‘guaranteed’ rate of return on a loan or investment is riba. Riba, in all forms, is prohibited in Islam. Usually, riba and interest are used interchangeably.

salam
Salam means a contract in which advance payment is made for goods to be delivered later on. Shari’ah Refers to the laws contained in or derived from the Quran and the Sunnah (practice and traditions of the Prophet Muhammad (PBUH)

Shari’ah board
An authority appointed by an Islamic financial institution, which supervises and ensures the Shari’ah compliance of new product development as well as existing operations.

shirkah
A contract between two or more persons who launch a business or financial enterprise to make profit. sukuk
Similar characteristics to that of a conventional bond with the key difference being that they are asset backed; a sukuk represents proportionate beneficial ownership in the underlying asset. The asset will be leased to the client to yield the return on the sukuk.

ta’awuni
A principle of mutual assistance. tabarru A donation covenant in which the participants agree to mutually help each other by contributing financially.

takaful
A form of Islamic insurance based on the Quranic principle of mutual assistance (ta’awuni). It provides mutual protection of assets and property and offers joint risk sharing in the event of a loss by one of its members.

tawaruq
A sale of a commodity to the customer by a bank on deferred payment at cost plus profit. The customer then a third party on a spot basis and gets instant cash.

ummah
The diaspora or ‘Community of the Believers’ (ummat al-mu’minin), the world-wide community of Muslims.

wa’ad
A promise to buy or sell certain goods in a certain quantity at a certain time in future at a certain price. It is not a legally binding agreement.

wakala
A contract of agency in which one person appoints
someone else to perform a certain task on his behalf, usually against a certain fee.

waqf
An appropriation or tying-up of a property in perpetuity so that no propriety rights can be exercised over the usufruct. The waqf property can neither be sold nor inherited nor donated to anyone.

zakat
An obligation on Muslims to pay a prescribed percentage of their wealth to specified categories in their society, when their wealth exceeds a certain limit. Zakat purifies wealth. The objective is to take away a part of the wealth of the well-to-do and to distribute it among the poor and the needy.